Auto Dealer Valuation Insights Blog

Regular updates on issues important to the Auto Dealer industry

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The Role of the Third Appraiser

After watching some controversial calls unfold this past weekend during the NFL playoffs, I couldn’t help but draw the correlation between throwing the challenge flag and looking for a third appraiser. Overtime in a playoff game, win or go home, the situation is as intense as it gets. Similarly, when a buy-sell agreement calls for a third appraiser, the stakes are high and it is fairly late in the game.

Latest Insights

December 2025 SAAR

The U.S. auto industry closed 2025 with modest sequential improvement, surpassing 16 million units for the first time since 2019. While volumes stabilized late in the year, continued year-over-year declines, rising incentives, and uneven inventory levels across brands highlight a market that is normalizing rather than accelerating. As the industry moves into 2026, disciplined inventory management and margin preservation will be critical drivers of dealer performance and franchise value.

PODCAST | Beyond the Lot: Understanding Dealership Valuations

with Kevin Timson and David Harkins

Mercer Capital Vice President David Harkins was recently featured on the podcast Beyond the Lot: Understanding Dealership Valuations, hosted by Kevin Timson, for a wide-ranging conversation on the factors that truly drive value in automotive dealerships. Drawing from his experience advising auto dealers nationwide, David discusses how elements such as brand strength, real estate, fixed operations, and local market dynamics influence dealership valuations.

November 2025 SAAR

The November 2025 SAAR improved to 15.6M, yet industry volumes posted a second month of year-over-year declines amid tariff impacts and expiring EV incentives. After September’s tax-credit rush, BEV market share has fallen by more than half, signaling a sharp reset in EV sales momentum. Finally, despite likely topping 16M units for 2025, per-unit profitability is slipping, and dealer performance is increasingly dependent on brand-specific inventory discipline.

Beyond the SAAR: What Really Drives Auto Dealership Value

Because the federal government has just reopened, the official data for the monthly light-vehicle SAAR (Seasonally Adjusted Annual Rate) is not yet available. In the meantime, we invite you to download and review our whitepaper, “Understand the Value of Your Auto Dealership.”

Understanding Reinsurance for Auto Dealers (Part II)

Valuation and Planning Considerations

In this post, we discuss the valuation implications of reinsurance on auto group corporate planning and ownership estate planning options, and contrast them to core dealership operations as well as the real estate owned by the auto group.

Understanding Reinsurance for Auto Dealers (Part I)

What It Is and Why It Matters

In the first post of this series, we introduce the basics of reinsurance in the context of auto dealerships and explore both the pros and cons of establishing a reinsurance company.

August 2025 SAAR

In August 2025, the U.S. auto industry slowed as the SAAR of 16.1 million units represented a 2.9% decrease from the prior month. However, the trend of year-over-year increases continued, as eleven of the past twelve months have beat the prior year, with a 6.2% increase from August 2024. The August 2025 performance is particularly impressive given the inflated baseline from the previous year's CDK software outage that shifted sales into July and August 2024.

Themes from Q2 2025 Earnings Calls

In this week's post, we cover what auto retailer executives had to say during the Q2 2025 earnings calls. We noted three major themes from last quarter’s calls: tariffs, acquisitions, and fixed operations.

July 2025 SAAR

The July 2025 SAAR came in at 16.4 million units, up 7.1% from last month and up 3.7% from July 2024. It is important to note that this modest year-over-year gain requires a bit more context due to irregularly high sales this time last year. The June 2024 CDK software outage shifted sales into July and August 2024, making July 2025’s year-over-year performance even more impressive.

Blue (Sky) Is in the Eye of the Beholder – Part 2

Ongoing Earnings and Other Valuation Considerations

In this post, we discuss our perspective on how dealership earnings are evaluated, adjusted, and normalized, based on our experience and discussions with dealmakers in the space.

June 2025 SAAR

The June 2025 SAAR came in at 15.3 million units, down 1.7% from last month but up 2.3% from June 2024. When looking at the year-over-year comparison, it is important to consider that June 2024 sales were impacted by the CDK software outage. As such, the year-over-year change in the SAAR presents the June 2025 performance in a better light than it would be without the impact of the 2024 CDK event.

Overview of Auto Finance in 2025

Origination, Delinquency, and Portfolio Trends

Experian releases a “State of the Automotive Finance Market” webinar every quarter. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2025. We discuss in this post.

May 2025 SAAR

The May 2025 SAAR came in at 15.6 million units, down 9.3% from the previous month and representing a 1.1% decline from May 2024.

Blue (Sky) Is in the Eye of the Beholder – Part 1

Perspectives on Auto Dealership Blue Sky Multiples and Valuations

On a recent client engagement, I was asked the question, “Why are Haig and Kerrigan’s multiples so far apart?” I’ve never really viewed them that way, as the blue sky multiples published in their quarterly newsletters tend to cluster reasonably close together.

April 2025 SAAR

The April 2025 SAAR came in at 17.3 million units, down 3.1% from last month but up 7.8% from April 2024. Even with a slight month-over-month decline from the short-term peak of last month’s SAAR, April 2025 still saw the second-highest SAAR since April 2021. This highlights the strong demand in the current market as consumers are motivated to purchase a vehicle before potential tariff-related price increases.

Estate Planning for Auto Dealers

For this week’s edition of Auto Dealer Valuation Insights, we revisit a timely article on estate planning for auto dealerships.

April 2025 Auto Industry Tariff Update

Where Do We Stand and What Does That Mean for My Dealership?

The U.S. automotive industry has been navigating an increasingly uncertain landscape since the 2024 presidential election. Given how deeply globalized the industry is, automotive manufacturing often involves complex supply chains where parts and materials may cross borders multiple times before a vehicle reaches the end consumer.

March 2025 SAAR

The March 2025 SAAR came in at 17.8 million units, up a staggering 11.0% from last month and 13.3% from March 2024. March 2025 saw the highest SAAR since April 2021, reflecting not only the recent trend of strong consumer demand but also the additional demand generated by consumers motivated to purchase a vehicle to avoid potential tariff-related price increases.

Q4 2024 Earnings Calls

Auto Industry Volumes and Per-Unit Profitability Continue to Normalize

Themes for this seasons' earnings calls were 1: Volume growth and GPU normalization in the new vehicle market, Technician expansion and strong profitability in Parts and Service, and Policy uncertainty in the U.S. surrounding tariffs and EVs

February 2025 SAAR

The February 2025 SAAR came in at 16.0 million units, up 3.2% from last month and 2.1% from February 2024. While February typically records one of the lowest sales volumes each year, this month's SAAR exceeded the average of the last five Februarys (approximately 15.3 million units). February 2025 performance reflected strength in consumer demand, primarily driven by improved inventory and incentive spending.

Nissan’s Search for a Merger Partner

If you own or manage a Nissan dealership, you likely have questions about what the company’s next steps mean for your business. Many of these questions are prudent, as Nissan’s ongoing search for strategic partnerships could still have significant implications for dealers down the line. Below are the key factors that could shape the future for Nissan dealers.

January 2025 SAAR

The January 2025 SAAR came in at 15.6 million units, down 7.5% from last month and up 3.8% from January 2024. January is typically one of the lowest months of sales volume each year, but as seasonal adjustments usually account for this, it is notable that this month’s SAAR dipped to the lowest point since January 2024. It is also worth mentioning that this month’s SAAR exceeded the average of the last five Januarys (approximately 15.4 million units).

New Update: Understand the Value of Your Auto Dealership

If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.

December 2024 SAAR

The December 2024 SAAR came in at 16.8 million units, just slightly higher than last month and up 4.2% from December 2023. Notably, this month’s SAAR outpaced the last three Decembers and was the highest monthly SAAR since May 2021 (17.0 million units).

What Is the Makeup of the Car Parc?

Data from Q3 2024

Each quarter, Experian releases an Automotive Market Trends report. This report includes vehicle registration data from each state's Department of Motor Vehicles, vehicle manufacturers, and captive finance companies. This week, we summarize the data from the Q3 2024 report and add insights for our dealership audience.Vehicles in OperationThe makeup of vehicles in operation ("VIO") in the U.S. and Canada can be a leading indicator of what to expect from automotive sales over the medium term. For example, VIO can inform industry-wide estimates of what models are currently the most popular to own, how many of those models should be manufactured, and, inevitably, how many should be marketed and sold. These estimates can be made based on changes in VIO, the average age of VIO, and what vehicle segments and brands make up VIO.Changes in Total VIO over the Past YearAs of Q3 2024, VIO in the United States and Canada was 341.9 million. This includes light vehicles (cars, pickup trucks, SUVs, etc.) as well as medium and heavy-duty vehicles (large vans, delivery trucks, RVs, etc.) and power sports vehicles (motorcycles, snowmobiles, etc.). While tracking total VIO can be a valuable insight from a macroeconomic perspective, light vehicle totals are the most relevant to our auto dealer clients.In the U.S. and Canada, light duty vehicles in operation were 292.1 million on September 30, 2024, a positive difference of 3.6 million units or 1.2% higher than the same figure in Q3 2023. In fact, light-duty VIO has increased by 3.6 million units for two years in a row. These two consecutive, identical increases may have happened by chance but certainly highlight a longer-term trend of expansion in the car parc due to increased manufacturing activity post-COVID and fewer retirements due to longer-lasting vehicles. A segment of consumers being financially stretched also contributes to an increasing age of VIO. The specific components of light vehicle VIO change over the last twelve months are 15.6 million new vehicle registrations minus 12.0 million vehicles taken out of operation. See the chart below for a visualization of the change in VIO over the last year. New vehicle registrations were up 5.3% to 4.0 million during the third quarter of 2024, while used vehicle registrations were up 2.0% to 10.1 million. These positive growth rates over the third quarter tell the story of the past two years for the auto dealer industry: new vehicle inventories have been recovered for some time now after the pandemic and ensuing disruption from the chip shortage in 2020-2022 when registrations of both new and used vehicles fell before changing course and normalizing over the last two years. As one might expect, used vehicle transactions do not directly affect VIO. These types of transactions do not add new vehicles to the car parc but rather represent existing vehicles changing hands. Over the past year, approximately 38.9 million used vehicles changed owners. When you combine the retirement of used vehicles and used vehicle changing-of-hands transactions, 17.4% of the total car parc was involved in a used vehicle transaction or retirement over the past year. VIO by Model YearOver the past decade, drivers have been holding on to their vehicles for longer, partially due to improved longevity in modern vehicles and, at times during the pandemic, due to market conditions like availability and pricing of new and used vehicles. Factors are also at play, such as persistently high transaction prices for new vehicles and consumer worries over the shift to electric vehicles.The average age of a vehicle on the road hit 12.6 years in May 2024, according to Business Insider, which is up from 2023's average and marks the seventh year in a row that the average age of vehicles on the road has increased. In the context of an aging car parc, most of the country's VIO is still newer than 20 years old. As of Q3 2024, 83.9% of total VIO was less than 20, and 93.1% were less than 25 years old.According to the Automotive Market Trends report, there is an aftermarket "sweet spot" for the age of used vehicles, namely six to twelve years. This sweet spot is close to when most vehicles age out of general manufacturer warranties for repairs. As of Q3 2024, 36.2% of total VIO were within the used vehicle sweet spot (model years 2013 – 2019). This proportion is 0.4 percentage points higher than last year and 5.3 percentage points higher than the same time in 2020 when the pandemic was in full swing. Going forward, Experian expects the sweet spot to continue growing until 2026. It is not a coincidence that the sweet spot is expected to stop growing six years after 2020, as pandemic-affected manufacturers released fewer vehicles during the pandemic years than before.From the perspective of auto dealers, the ever-increasing average age of VIO is a double-edged sword. On one hand, a higher average age is likely to increase the volume of parts and service departments nationwide. Parts and service margins are among the most favorable of a dealership's profit centers, and dealers should look forward to increased work. On the other hand, a higher average age means consumers are purchasing vehicles less frequently, which could put slight pressure on selling departments.VIO by Vehicle Source, Type, and SegmentLooking at the makeup of VIO by domestic vs import, 58% of light-duty VIO were import models, and 42% were domestic models during Q3 2024. This represents a notable change from 52% import / 48% domestic just one year ago and emphasizes struggles by domestic manufacturers in recent years. Domestic automakers have lost market share to imports due to consumer perceptions of better reliability, technology, and fuel efficiency from foreign brands. Furthermore, challenges like a slower adaptation to trends such as electric vehicles have further hindered competitiveness between domestic and import brands.Splitting light-duty VIO by type, SUVs/Crossovers (56.7% of total light-duty VIO), passenger cars (20.8%), and light trucks (22.5%) all contribute to light-duty VIO. SUVs and crossovers have exploded over the last few years, making up a larger share of light-duty VIO each period. These vehicles have gained market share from cars due to their versatility, higher seating position, and increased cargo space, which appeals to families and consumers with active lifestyles. The improved fuel efficiency of these models in recent years has made them more practical, while their perceived safety has also drawn consumers away from traditional sedans.These broad vehicle types can be divided into around 20 more specific vehicle segments. The full-size pickup truck segment is the most popular in the United States, representing 16.4% of total VIO. Full-size pickup trucks are followed by midsize cars (13.0%), midsize crossovers (12.7%), and compact cars (8.1%). In recent years, midsize cars have lost some of their share to crossovers and compact cars. Looking at trucks specifically, as of Q3 2024, the Ford F-150 (3.7% of total VIO) and the Chevrolet Silverado 1500 (2.7%) were the two most popular models on the road.VIO by ManufacturerVIO by manufacturer is another way that the car parc can be analyzed. See the chart below for a look at VIO by manufacturer market share. General Motors, Ford, and Toyota are the most popular manufacturers in this cross-sectional data snapshot. VIO by manufacturer data represents what vehicles are currently on the road and includes vehicles of all ages, not just new vehicles. This data does not reflect consumer satisfaction or current sales trends but typically lags because it is more long-term focused. Therefore, this data is best viewed as a rearview mirror rather than a windshield for the industry, though it gives an eye into parts and service departments today. Going forward, we expect these proportions to slowly shift towards prevailing sales trends. GM and Ford continue to lead the way, representing 20.5% and 15.7% of total VIO, respectively. However, these two domestic manufacturers have slowly lost market share to import brands in recent years. The best example is Toyota, which has gained over the last couple of years but still lags behind Ford and GM. Perhaps we may see Toyota jump Ford and approach GM in total VIO soon. Kia is another notable mover on this list over the last year, as it gained two percentage points and jumped one spot from tenth to ninth. In some ways, this data reflects what we've seen with auto dealership values. For example, Toyota has outperformed, as seen in the graph above, which has translated to higher dealership values as reflected in Blue Sky multiples. About UsMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

November 2024 SAAR

The November 2024 SAAR came in at 16.5 million units, which is 1.5% higher than last month and 6.2% higher than November 2023. Of note, November 2024 had one more selling day than November 2023.

Inventory Management Strategies for Franchised Auto Dealers

While dealers cannot control their allocation from OEMs, they can and should respond with the most appropriate sales strategy for the inventory they receive. There are two main approaches available to dealers: maximize price or volume. The key is balancing these strategies to optimize both sales and profitability. We discuss the pros and cons of each below.

October 2024 SAAR

The October 2024 SAAR came in at 16.0 million units, 1.7% higher than last month and 3.7% higher than October 2023. A strong October 2024 SAAR was accompanied by increased inventories and incentive spending levels industry wide, which put pressure on transaction prices and dealership profits.

2024 NADC Fall Conference Update

Key Takeaways for Auto Dealers

We provide a few takeaways from sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients during the remainder of the year and beyond.

September 2024 SAAR

The September 2024 SAAR came in at 15.8 million units, 3.3% higher than last month and in line with September 2023. At their September meeting, the Federal Reserve cut benchmark interest rates by 50 basis points and highlighted a slight rise in unemployment. This won’t directly or dramatically impact the industry, but we do expect to see the effects of this rate cut (and likely forthcoming cuts) within the industry over the next couple of months and into 2025.

Where Is the Auto Dealer Industry in the Cycle?

For years, it’s been a question of when, not if, things would normalize. The more difficult follow-up question has been, “Where will earnings and margins normalize?”

August 2024 SAAR

The August 2024 SAAR came in at 15.1 million units, notably 4.5% lower than last month. In fact, this month’s SAAR is even lower than June, which was negatively impacted by the CDK cybersecurity attack. We believe consumers are likely finally feeling the pain of a softer labor market, as indicated by the July 2024 Jobs Report from the Bureau of Labor Statistics.

Q2 2024 Earnings Calls

Here is what auto retailer executives had to say during the Q2 2024 earnings calls.

July 2024 SAAR

The July 2024 SAAR came in at 15.8 million units, a 4.2% increase from last month and roughly flat with July 2023 (-0.8%). While the month-over-month increase was expected based on the CDK cyber-attack that hit the auto dealer industry in late June, we find it notable that results were still below last year.

Personal Goodwill in the Auto Industry

This post discusses important concepts of personal goodwill in divorce litigation engagements. The discussion relates directly to several divorce litigation cases involving owners of automobile dealerships. These real-life examples display the depth of analysis that is critical to identifying the presence of personal goodwill and then estimating or allocating the associated value with the personal goodwill. The issues discussed here pertain specifically to considerations utilized in auto dealer valuations, but the overall concepts can be applied to most service-based industries.It is important that the appraiser understands the industry and performs a thorough analysis of all relevant industry factors. It is also essential to determine how each state treats personal goodwill. Some states consider personal goodwill a separate asset, and some do not make a specific distinction for it and include it in the marital assets.

June 2024 SAAR

The June 2024 SAAR came in at 15.3 million, a 4.0% drop from last month and a 4.8% drop from June 2023. According to Wards Intelligence, the CDK cyberattack caused a 50,000-unit deficit during June 2024; however, second-quarter sales were still relatively flat (-0.4%) from the second quarter of 2023 as only 11 of 91 days were impacted in the quarter.

The Latest on CDK Global Cybersecurity

Risks Come into Focus after Lurking in the Shadows

As frequent auto conference attendees and sponsors, we discuss trends in the industry with other service providers. In an increasingly digital world, we’ve noted an increase in service providers catering to cybersecurity in a variety of ways. While no dealer gets excited about spending thousands of dollars to mitigate risks rather than grow profits, the CDK Global cyberattack may be a watershed moment for the industry.

2024 State of Auto Finance

Origination, Delinquency, and Portfolio Trends

In this year’s "2024 State of Auto Finance," we review these themes and lay out new developments and changes in auto finance since this time last year.

May 2024 SAAR

The May 2024 SAAR was just shy of the 16 million mark, coming in at 15.9 million units, generally flat from last month (+0.8%) and reflecting year-over-year growth of 2.5%. Throughout the pandemic years, the auto industry was defined by volatility and uncertainty as inventory levels plummeted and transaction prices skyrocketed. In the first half of 2024, however, we have seen more stability in the SAAR as inventory levels rise and transaction prices moderate.

Mid-Year 2024 Review of the Auto Dealer Industry by Metrics

Tray Tables Up?

In this post, we discuss several key metrics we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, fleet sales, and vehicle miles traveled.

What Is the Market Approach and How Is It Utilized for Auto Dealer Valuations?

The market approach enables analysts to determine a value indication by comparing the subject auto dealership to other similar dealerships. These comparable dealerships could be similar in size, geographic location, or, most importantly, franchise.

Hybrid Vehicles and the Goldilocks Principle

EVs Get the Headlines While Consumers Are Getting Hybrids

In this week's post, we touch on recent developments with electric vehicles and how they are leading to a surge in demand for hybrids.

April 2024 SAAR

The April 2024 SAAR was 15.7 million units, reflecting generally flat month-over-month (+1.1%) and year-over-year (+0.4%) growth. Over the last several months, we have seen more stability in the SAAR than we have seen since the pandemic. This stability will likely give confidence to dealers and consumers alike after years of volatility and uncertainty in transaction prices and vehicle availability. Inventory levels, increased incentive spending, average transaction prices, and per-unit dealer profits will all be discussed later in this post.

One Dealer Is Not Like the Other

Independent Dealers Industry Segment Highlight

This week, we highlight the auto dealer market: independent dealers.

What Is the Income Approach and How Is It Utilized for Auto Dealer Valuations?

The income approach is based on capitalizing future expected cash flows using estimates of risk and growth specific to the subject dealership. This analysis is incredibly important for auto dealerships due to the expected future cash flows of most dealerships being the primary driver of value.

2024 NADC Conference Key Takeaways

In this post, we provide a brief list of takeaways from a few of the sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients to watch during the remainder of the year and beyond.

March 2024 SAAR

The March 2024 SAAR was 15.5 million units, a 1.3% decrease from last month and a 3.7% increase compared to this time last year. The year-over-year sales improvement, along with declining transaction prices and generally flat inventory levels, may indicate that the industry is reverting to pre-pandemic trends.

Just Released: Year-End 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter. The newsletter features industry data from year-end 2023. Additionally, this issue includes two timely articles: "Q4 2023 Earnings Calls" and "No Soup for You: Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry."

Public Auto Dealer Profiles: Group 1 Automotive

We talk a lot about the differences between most privately held and publicly traded auto dealers. Scale, diversification, and access to capital make the business models different, even if store and unit-level economics remain similar. Public auto dealers provide insight into how the market prices their earnings, the environment for M&A, and trends in the industry.

News Update: How the Collapse of the Baltimore Bridge Might Impact the Auto Supply Chain

By now, most of us have seen the harrowing images of cargo ship Dali wrecking into the Francis Scott Key Bridge in the Port of Baltimore in the early morning hours on Tuesday. Besides the tragedy of lives lost, the disruption for Baltimore commuters, and the time needed for recovery and rebuilding of the bridge, the catastrophe will have a major impact on the global supply chain and will also impact the auto supply chain. But how?

It’s Not About the Mangos: Focus on People

What We've Been Reading

With school in the home stretch and summer just around the corner, I wanted to share some insights I learned from reading “It’s Not About the Mangos” by Kent Coleman.

Q4 2023 Earnings Calls

New Vehicle Resilience, Lightly Used Inventory Scarcity, and Disappointing EV Sales

After reviewing earnings calls from executives of the six publicly traded auto dealers, the market for new vehicles appears resilient. Improved inventory balances and wider availability of models have relieved pressure from the new vehicle market. As a result, transaction prices have been falling, and consumers have been able to find the models they are looking for with more success. Meanwhile, used vehicle availability has been mixed, with lightly used models falling short. However, the demand for electric vehicles has been disappointing, and capital allocation decisions have become more complicated in the current environment.

February 2024 SAAR

The February 2024 SAAR was 15.8 million units, a 6.0% increase from last month and a 6.3% increase compared to this time last year. February 2024’s year-over-year sales improvement and consistently improving inventory levels may indicate that the industry is reverting to its pre-pandemic ways. As nationwide inventory balances continue to expand, incentive spending from auto manufacturers has followed in tandem as OEMs and retailers compete to draw in buyers. Check out our recent blog for a deep dive into Customer Lifetime Value and the importance of getting buyers in the door for both dealers and manufacturers.

An Estate Planning Primer

Why Auto Dealers Need to Start Thinking About Estate Planning Again

One thing we’ve hardly written about in this space is estate planning, in part because dealerships have experienced record performance. However, as record profits have receded towards more normalized levels, and with the significant cliff looming at the end of 2025, it’s time for auto dealers to revisit their estate planning.

No Soup for You

Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry

Like the price elasticity of automobiles, especially high-end automobiles, OEMs and auto dealers must confront the challenges of brand loyalty and customer retention. In this week’s post, we discuss customer lifetime value ("CLV") and cost of customer acquisition ("CAC") and offer tips to auto dealers to achieve greater customer retention.

How a Quality of Earnings Analysis Benefits Auto Dealership Buyers

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.

January 2024 SAAR

The January 2024 SAAR was 15.0 million units, down 6.9% from last month and roughly flat (down 0.7%) compared to this time last year. Following 17 consecutive months of year-over-year improvements, the January 2024 SAAR ended the streak with a slight decline. Since January is generally a low-sales month, a decline in the SAAR itself does not necessarily dampen expectations for the remainder of 2024.

Understanding the Asset Approach

What Is It and How Is It Used for Auto Dealer Valuations?

Everyone in the auto dealer industry has likely heard of Blue Sky values. Under the market approach, valuation professionals add the indicated Blue Sky value to the dealership’s tangible net asset value. This is where the asset approach comes into play.

Vroom in the Tomb and Used Vehicle Gloom

What Does the Collapse of Vroom Say for Auto Dealers?

Vroom and other used-only dealerships are more squeezed because they aren’t tied to a franchise. They can only sell used vehicles whose prices have been more volatile, and they don’t have access to captive financing from their OEMs. In short, we don’t think traditional franchise dealers will be stung by the forces that took down Vroom. However, we believe Vroom shouldn’t be ignored as it can provide valuable insights. Its S-1 highlighted e-commerce penetration in the industry sits at just under 1%, compared to about 16% for total retail.

2024 Automotive Trends

A Look Back to Look Forward

Following the auto industry rollercoaster of the past two and a half years, perhaps 2024 will be a return to the times before the pandemic. If not, this could be our new normal. Margins and profitability have already declined in the latter half of 2023. The buying process for vehicles has forever changed, offering online and omnichannel options to the traditional in-person experience at the dealership. While inventory supply from the OEMs continues to improve, will it level off, or will it also climb back to pre-pandemic levels in 2024?

December 2023 SAAR

The December 2023 SAAR was 15.8 million units, up 3.2% from last month and up 16.8% compared to this time last year. After only two months of single-digit year-over-year improvements, the December SAAR returned to double-digit year-over-year growth. The December SAAR marks a strong finish to 2023, with growth in line with the double-digit percent increases seen from March to September. The December SAAR extended the streak of consecutive year-over-year improvements to 17 months.

What Is the Car Parc Makeup?

Data from Q3 2023

‘Twas the Blog Before Christmas...

2023 Mercer Capital Auto Dealer Holiday Poem

Enjoy our year-end poem.

Auto Dealer Insights: Best of 2023

We are about to put a bow on 2023! Our weekly posts follow the auto industry closely to keep up with market trends and gain insight into the private dealership market. We hope you have enjoyed our content in 2023, and we look forward to connecting further in 2024! Below, we have recapped four of our popular topics.Auto Industry Trends to Monitor in 2023Early in the year, we wrote a post discussing a potpourri of trends to monitor in 2023, coming off specific statistics from 2022. We discussed new vehicle pricing, used vehicle pricing, electric vehicles, connected cars, and SAAR predictions for 2023. As we close out 2023, we revisit some of these topics and predictions in hindsight.The average transaction price for new vehicles continued to rise in early 2023 before flattening out and eventually declining. As of the most recent data, the average transaction price of new vehicles stood at $45,332 in November, representing a decline ranging from 1.5-2%, depending on the source. Consistent with those trends, incentives on new vehicles have steadily risen and now comprise approximately 4.5-5%, depending on the source. Finally, the percentage of new vehicles selling above MSRP is 21.4%, compared to nearly 37.1% from this time last year, according to JD Power/LMC. All of these trends indicate that we are shifting from a seller’s market to a buyer’s market for automobile consumers.Average transaction prices for used vehicles also followed suit, posting a figure of $29,985 for November, a decline of approximately 2.9% from November 2022.Avid readers are familiar with our monthly SAAR reports. With a strong December, which is typically the strongest selling month of the year, the annual SAAR is expected to land somewhere in the area of 15.6 million units. As a point of reference, predictions for 2023 ranged from 14.1 to 15 million from industry experts such as Edmunds, Cox Automotive, NADA, and Toyota North America. After underperforming expectations in 2022, predictions were reigned in, and the rebound materialized in 2023, outstripping expectations.EV PotpourriAccording to Automotive News, EVs continued to increase market share, with estimates ranging from approximately 7% at the beginning of the year based on the total number of new vehicle registrations to 8.6% in June. This post discussed the different charging levels, various requirements automakers have for their dealers, and the expanding presence of charging stations at retailers and restaurants.Later in the year, we discussed the recent development of EV affordability, as well as a view of consumer demand measured by days’ supply of EV inventory versus all vehicles. EVs continue to be more expensive than their internal combustion engine (ICE) counterparts, with average transaction prices of $55,436 and $41,630 for new and used EVs, respectively. Only five of the twenty new EV models to be introduced in 2024 will be offered at prices below the average transaction price for all new vehicles.While production of EVs has increased, the amount of EV inventory on dealers is beginning to mount, perhaps reflecting a softening interest in these models. For all OEMs other than Chevrolet and Cadillac, the days’ supply of inventory for EVs is far more than the days’ supply of all new vehicle inventory. Stated simply, EV inventory is sitting on dealers’ lots for extended periods compared to ICE vehicles.Ford recently announced it is scaling back its $3.5 billion Michigan battery plant as EV demand has declined and labor costs have increased.United Auto Workers StrikeThe increase seen in labor costs is due to the UAW strike, which began on September 15th and ended on November 20th, when new deals were ratified. Our October 6th post chronicled the strike in real time, including insights into why the union was striking, the key players in negotiations, and how this strike differed from previous ones. Historically, the UAW only targeted one OEM at a time during a strike. But as this was the first simultaneous strike against the Big 3, it enabled the UAW to use concessions by one OEM as negotiation leverage with the others. Possibly learning from the recent supply chain constraints, the strikes also targeted specific factories that produce the most popular and profitable vehicles, allowing the UAW to inflict maximum economic pain while limiting the interim losses of its striking members.The new contract gave union workers an immediate pay increase of 11%, and union members will get a total pay increase of 25% throughout the 4½-year deal. The new contracts also reinstated cost-of-living adjustments, let workers reach top wages in three years instead of eight, and protected their right to strike over plant closures.For comparison sake, we noted reports that the UAW was seeking: As expected, the UAW gained some valuable concessions but also didn’t get everything they were seeking. Floorplan Interest Income FadingIn the post-COVID and supply chain-constrained boom, auto dealers enjoyed an unlikely profit center: floorplan interest. Floorplan loans are provided to dealers by banks, specialty lenders, and vehicle manufacturers. Interest accrued on these loans is called floorplan interest, and in the time between when the vehicle is acquired by the dealer and sold to a consumer, the dealer must pay floorplan interest expense to the lender. The longer the vehicle sits on the lot, the longer interest accrues.When dealers started selling vehicles as soon as they arrived at the dealership, floorplan credits exceeded floorplan interest expense. Normally a cost of doing business, low interest rates coupled with depressed inventories meant the sales-volume-based credits many dealers receive from their OEM exceeded the financing cost of holding vehicles on the lot.As we noted in our post this year, this began to fade in 2023 as inventories recovered and rates remained elevated. With no end in sight, they continued to rise as many Fed watchers anticipated a “higher for longer” interest rate environment.

November 2023 SAAR

The November 2023 SAAR was 15.3 million units, down 0.7% from last month but up 7.4% compared to this time last year. As demonstrated by a second consecutive single-digit year-over-year improvement, the industry continues to grow slower than the double-digit percent increases seen from March to September.

Return to Status Quo or a New Normal?

Auto Leasing Trend Update

Consumers are typically faced with two options when considering their next vehicle transaction at the dealership: buying an automobile or leasing one.

Key Takeaways for Auto Dealers from the 2023 AICPA Dealership Conference

Last month, we attended the 2023 AICPA Dealership conference and in this post present key takeaways from two sessions that are of interest to our blog readers: “Driving Success in Auto Retail” and “The Electrification of Auto Retail.”Key Takeaways: "Driving Success in Auto Retail " Session This session was presented in the form of a conversation between Alan Haig of Haig Partners and Daryl Kenningham, CEO of Group 1 Automotive. Group 1 Automotive owns approximately 205 auto dealerships in the United States and the United Kingdom and boasts approximately $16 billion in annual revenues. They specifically own 150 auto dealerships in the United States, with headquarters and a high concentration of dealerships in the Houston, Texas market. (For information on other publicly traded auto dealers, see our ongoing blog series featuring profiles on Asbury Automotive Group, Auto Nation, Sonic Automotive, and Lithia Motors.)Here are the key takeaways for our readers.The Service Experience for Tesla Consumers May Not Be OptimalWhile Tesla consumers have loved the direct sales model buying experience, they have not enjoyed the service experience. As we’ve discussed, franchised auto dealers have implemented elements of the direct sales model through digital/online platforms. Unlike Tesla, franchised auto dealers have physical locations near their customer bases and are more equipped to provide ongoing service for the life of their vehicles.There Is a Used Car ShortageWith more focus on the shortage of new vehicles produced in the last three years caused by the pandemic and microchip shortage, the shortage of used vehicles hasn’t been as widely discussed. Fewer new vehicles sold leads to fewer trade-ins, which leads to fewer used vehicles for sale. Mr. Kenningham estimated that 8 million fewer used cars are available in the system even though approximately 40 million used vehicles trade hands annually. Also contributing to the system’s shortage of used vehicles are consumers maintaining their current vehicles longer, fewer new units available, as well as affordability issues.There Is a Technician ShortageGroup 1 and other auto groups have countered the lack of skilled technicians in the workforce by gradually raising labor rates. While this strategy has been effective, it has led to costlier repairs on average and, eventually, a ceiling on these increased rates. Mr. Kenningham estimated that an empty service bay would cost the company $17,000 in gross profit each month.It Is Hard to Retain a Service Department CustomerMr. Kenningham estimated that Group 1 and other franchised auto dealers only retain approximately 2/3 of service customers from new vehicles they sell directly. The Service Department is one of the higher margin segments in the auto dealership business model; therefore, it’s important for dealers to try to retain more ongoing service work for their current customers. While oil changes and tire rotations are not very profitable to auto dealers, they provide frequent/additional opportunities for the auto dealer to service the customer.Younger Customers Are Not Loyal CustomersYounger customers are more inclined to seek out the purchase of a new automobile on a digital platform because of the comfort of making material purchases in that format. However, younger customers tend to be less loyal in the long run, so auto dealers must strike a balance in their sales offering methods to the customers.The 3 Things Dealers Should Focus OnConsistent with these trends and observations, Mr. Kenningham listed three things that auto dealers should focus on in the future:Invest in technology,Invest in customers, andDrive scale into all elements of your business model.Key Takeaways: "The Electrification of Auto Retail – 2023 Update" SessionThis presentation by Capital Automotive provided a snapshot of the current landscape for the electric vehicle (EV) market as well as a comparison of industry conditions and headwinds in 2021 versus 2023. Specifically, the headwinds in 2021 were cost parity to traditional internal combustion engine (ICE) vehicles, consumer adoption/demand, and the charging network. These headwinds primarily still exist in today’s environment.Affordability and Value Retention Are a Question MarkThe following graph from information provided by Cox Automotive details the average new and used price trends from battery electric vehicles (BEVs): Source: Cox AutomotiveClick here to expand the image aboveIn September 2023, the average transaction price for a new BEV totaled $55,436 compared to the $47,899 average transaction price for all new vehicles (Cox Automotive). For used vehicles, the average transaction price for BEVs was $41,630 compared to $28,935 for all used vehicles (Edmunds).In addition to higher transaction prices, the six BEV models in the following graph are projected to lose 25%-42% of their value five years after purchase. This may seem like a high percentage, but for comparison, Capital Automotive noted that an iPhone 11 lost ~75% of its value five years after purchase. Sources: AAA, AppleClick here to expand the image aboveFinally, Capital Automotive provided two other views of the affordability of BEVs/EVs. The first data point examined the cost of ownership of an F150 Platinum Truck (ICE) versus an F150 Lightning (BEV) comparing the cost of fuel, average insurance premiums, fees & taxes, interest financing, repairs & maintenance, and depreciation. The BEV (F150 Lightning) was 21% more expensive to own (by ~$4,000) than the ICE (F150 Platinum Truck) even though the BEV had lower fuel and repairs & maintenance costs.The second data point offered by Capital Automotive related to the cost of 2024 BEV models. According to Car & Driver, CNET, Kelly Blue Book, and U.S. News, 20 new BEV models are being introduced to the market in 2024. Only five of those models (Cadillac Celestiq, Chevy Equinox EV, Fiat 500e, Honda Prologue, and Volvo EX30) will be offered at prices below the average transaction price for all new vehicles.Consumer Demand Has Grown But ...Based on the statistics of U.S. new light vehicle sales, the EV unit’s share of the market is 8.6% as of June 2023, according to Automotive News. While this figure remains a small percentage of the overall market, it has grown from a meager 0.1% in just six and a half years.Another way to view consumer demand is in inventory levels, as seen in the graph below presented by Capital Automotive. Source: Axios, CarEdge, Seeking AlphaClick here to expand the image aboveOther than Chevrolet and Cadillac, EVs’ average days’ supply and inventory levels are higher than traditional ICE vehicles for all other manufacturers listed above. Dealers have plenty of EV inventory on their lots, but the pricier EV models are not selling as quickly and are beginning to pile up.The states with the fastest EV adopters are mostly in the west and northwest (California, Washington, Oregon, Nevada, Arizona, and Colorado). The states with the slowest EV adopters represent more of the country's rural areas (Wyoming, Iowa, Arkansas, Mississippi, South Dakota, North Dakota, and West Virginia).Charging Infrastructure Is Not SufficientThe specific needs of EVs, such as charging levels and requirements and infrastructure investments, are well-known in the industry. Additional challenges have been presented by fires caused by the combustion of lithium batteries in EVs in apartment buildings, airport parking garages, and cargo ships. According to a 2023 Electrical Safety Foundation Survey, 50% of homes in the United States do not have electrical systems capable of the continuous load required for EV charging, and 54% of all homes would require an electrical panel upgrade to facilitate EV charging.ConclusionThe recent AICPA Dealerships conference provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It’s also informative to hear how individual dealerships are confronting their own unique challenges. All of these trends/factors will continue to impact the operations of dealerships and, ultimately, their profitability and valuation.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members to understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

October 2023 SAAR

The October 2023 SAAR was 15.5 million units, down 1.2% from last month but up 5.6% compared to this time last year. As we predicted in last month’s SAAR blog, this month officially marks the end of a seven-month streak of consecutive double-digit year-over-year improvements in the SAAR. While we do expect to see double-digit improvements pop up over the next few months, the end of this streak is a reminder that the industry has been on the path to recovery for some time now and is slowing down to a more normalized, sustainable level.

Newly Released: Auto Dealer Video Series

In each episode of the 12-part series, you'll find practical advice, expert insights, and real-world examples created especially for any auto dealer looking to navigate the complexities of valuations and succession planning successfully. We hope you enjoy!

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Just Released: Mid-Year 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter.

September 2023 SAAR

The September 2023 SAAR was 15.7 million units, up 2.1% from last month and up 14.9% compared to this time last year. This month’s data holds true to the ongoing trend of double-digit year-over-year improvements. Altogether, this month marks the fourteenth straight month of year-over-year improvements in the SAAR.

United Auto Workers Strike

What It Means for Auto Dealers

Rising wages for automakers will ultimately raise MSRP, though as noted above, this was a likely outcome regardless of the strikes due to the larger share of profit realized by auto dealers in the past few years. A drawn-out strike would reduce vehicle availability, but with relatively higher Days’ Supply, domestic dealers can weather the storm if they can successfully steer consumers toward models that are in greater supply. If not, other brands stand to benefit from increased market share.

Do You Know How Much Your Dealership Is Worth?

Whitepaper: Understand the Value of Your Auto Dealership

August 2023 SAAR

The August 2023 SAAR was 15.0 million units, down 4.5% from last month but 13.6% higher than August 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong throughout the year. In fact, this month marks the thirteenth straight month of year-over-year improvements in the SAAR.

Q2 2023 Earnings Calls

Lower New Vehicle Supply Boost Fails to Lift Profits; Used Vehicle Prices Drop Amid High Demand

Reviewing earnings calls from executives of the six publicly traded auto dealers, new vehicle gross profit declined as inventory availability improved, though the decline in profitability was less than anticipated. While unit-level profitability is anticipated to continue to decline, there are signs of strength in consumer demand. Despite affordability issues, the market is anticipated to remain structurally above pre-pandemic levels.

Driving Value: Key Components of an Auto Dealership Valuation

Like most business owners, auto dealers are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are life events that make them need to know the value, such as a transaction (including buy-sell), litigation, divorce, wealth transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and consistently focusing on the value drivers of their auto dealership.

July 2023 SAAR

The July 2023 SAAR was 15.7 million units, almost exactly in line with last month’s SAAR but 18.2% higher than July 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong as the year goes on. In fact, this month is the twelfth straight month of year-over-year improvements in the SAAR, marking a full year of rising tides in auto sales volumes.

Toyota’s Steady State Battery

Breakthrough or Yet Another Long-Dated Production Target?

In early July, Financial Times reported Toyota’s solid-state battery breakthrough. According to Keiji Kaita, president of Toyota’s research and development center for carbon neutrality, the goal is to cut the size, weight, and cost of both liquid and solid-state batteries in half. In this post, we get into the details of this report, what auto dealers should know about solid-state batteries, and provide some context for realistic expectations. For consumers, we don’t recommend delaying your vehicle purchase by four years based on this news.

Mid-Year 2023 Review of the Auto Dealer Industry by Metrics

Cooling Statistics, But Perspective Is Key

As the summer winds down and we turn the calendar to August, the first half of 2023 is fully in the rearview mirror, and mid-year statistics for the auto industry have been released. How has the industry performed, and what do the metrics tell us about the direction the industry is headed for the remainder of 2023? In this post, we discuss several key metrics that we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, the used-to-new vehicle retail unit sales ratio, fleet sales, and vehicle miles traveled.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

June 2023 SAAR

Direct-to-Consumer Sales—Gaining Traction or Losing Their Footing?

The June SAAR was 15.7 million units, up 4.0% from last month and up 20.2% from June 2022. This June marks the 11th straight month of year-over-year improvements in the SAAR, and the magnitude of the improvements has continued to grow. As we laid out in last month’s SAAR blog, inventory levels were still dismal a year ago. The SAAR reported three straight months below 13.3 million units during June, July, and August of 2022. Inventory started to improve in August, and sales followed suit in September, sending the industry on the path to recovery. With this context in mind, we expect to see significant year-over-year increases in the SAAR for at least the next two months.

Overview of Auto Finance 2023

Origination, Delinquency, and Portfolio Trends

In this blog post, we review these themes and layout new developments and changes in the state of auto finance since this time last year.

Demise of the Sedan

Does Recent Data Suggest the Sedan Will Follow the Station Wagon and Minivan?

While recent data from the average age of cars, production of vehicle types by class, and fuel economy by vehicle type might suggest that light trucks/SUVs/crossovers will continue to overtake market share, I’m not ready to author the eulogy for the demise of the sedan/passenger car just yet. While it’s true that a proliferation of more light trucks/SUVs/crossovers on the roads means that taller/heavier vehicles might also shift the road-safety equation, there still could be momentum shifting the popularity back to sedans. While legislation helped fuel the growth and profitability of trucks, perhaps in the coming years, legislation or government mandates regarding electric vehicles will tilt the scales back towards the sedan or passenger car.

May 2023 SAAR

The Road Ahead: SAAR Predictions for the Rest of 2023

The May 2023 SAAR was 15.1 million units, a decrease of 6.5% from last month but an increase of 19.6% from this time last year. Last month also marks the tenth straight month of year-over-year improvements in the SAAR, highlighting almost a full year of rising tides in national auto sales. On an unadjusted basis, May 2023’s sales were up 22.8% from this time last year and are much closer to pre-pandemic levels.

6 Events That Warrant a Business Valuation of an Auto Dealership

What common events would require a business valuation of an auto dealership?

What Is the Value of My Auto Dealership?

It Depends on Who's Buying

In our Valentine’s Day-themed Levels of Value Blog Series, we discuss the theoretical considerations of the three distinct levels of value and how they apply to auto dealerships. In this post, we take a more practical approach to the discussion. When dealers ask themselves, “What is my auto dealership worth?” the answer is, “It depends on who’s buying.”

Infrastructure Investment for EVs, Data Privacy, and Dealership Buy-Back Programs

2023 NADC Conference Update

The National Association of Dealer Counsel (NADC) annual member conference was last week in Amelia Island, Florida. My colleague, Scott Womack, and I were happy to attend. In this week's post, we provide a few takeaways from the conference for readers to keep an eye on during the remainder of the year. At the end of the post is further reading about other topics presented at the conference.

April 2023 SAAR

The April 2023 SAAR was 15.9 million units, up 7.2% from last month and 11.4% from April 2022. This month’s improvements are significant for the month and the year as they emphasize the story that the data has been telling for months: vehicle availability has been improving, leading to higher sales volumes and more consistency in the SAAR. In fact, the year-over-year improvement in April marks the ninth straight month that the SAAR improved from the year prior. On an unadjusted basis, total sales for April came in at 1.39 million units, an improvement of 9.4% from April 2022. See the chart below for a comparison of the last eight April’s unadjusted sales.

Middle Men: Family-Owned Auto Dealerships

In this 5-minute video, originally recorded in May 2022 for Mercer Capital’s Family Business On-Demand Resource Center, Scott Womack addresses the topic of auto dealership valuation. He explains the economic and financial challenges that have affected the auto dealer industry and what drives the ultimate value of your dealership.

EV Potpourri

Discussing Levels of Charging to OEM Requirements of Dealers

News of electric vehicles (EVs) has permeated headlines in the auto industry as much as record profitability, supply chain issues, and microchip shortages over the last three years. While environment-conscious mandates and industry projections have framed the narrative on the overall popularity and adoption of EVs, several recent metrics have emerged that measure the momentum of EV sales. According to CleanTechnica, monthly EV sales exceeded 7% of all new light-duty vehicle sales in the U.S. for the first time in September 2022. Experian reported registration data from January 2023 that 7.1% of all new light vehicle registrations were all-electric vehicles.

March 2023 SAAR

Is North American Auto Production Lagging Behind?

The March SAAR was 14.8 million units, down 1.2% from last month but up 9.3% compared to March 2022. Year-over-year improvements in the SAAR continue to persist as inventory is more available compared to this time last year. In fact, this month marks the eighth month in a row of year-over-year improvements in the SAAR and signals consistency in auto production and auto demand trends. On an unadjusted basis, industry-wide sales numbers tell the same story. March 2023’s sales significantly improved from last year but remain below the levels seen in 2016 through 2019.

Public Auto Dealer Profiles: Asbury Automotive Group

Plan for the Unexpected

Succession Planning for Auto Dealers

Succession planning involves the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created. So, let's discuss a few of the key factors involved in the succession planning process and why they are so critical.

Q4 2022 Earnings Calls

Executives Anticipate a Return to Normal

Reviewing earnings calls from executives of the six publicly traded auto dealers, the consensus is that volumes will increase approximately 10% to about 15 million in 2023, but gross profit per unit (“GPU”) will decline as supply constraints are alleviated. Nobody is anticipating that record-setting unit-level profitability will continue, though most expect, or are at least hopeful, that “normalized” levels will be higher than pre-pandemic.

February 2023 SAAR

The February SAAR was 14.9 million units, down 6.3% from last month but up 8.6% from February 2022. Year-over-year increases in the SAAR have been a theme throughout the last several months. In fact, February 2023 marks the seventh month in a row that the SAAR improved from the year prior. Looking ahead, we believe that it is likely that year-over-year improvements will continue for several more months as nationwide inventory balances continue to recover.

2022 Auto Dealer Industry Metrics Review

Has Profitability Peaked?

2022 marked another very successful year for auto dealers. Most of the metrics discussed in this post seem to have peaked at some point during 2022 and are shifting in the other direction. Does this signal that profitability has peaked? Will increasing volumes compensate for declining unit economics? Only time will tell.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of Value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

Shareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.

January 2023 SAAR

The January 2022 SAAR was 15.7 million units, which is 18% higher than December 2022 and 4% higher than this time last year. This month’s data release revealed the fifth straight month of year-over-year improvements in the SAAR, supporting that inventory levels are actually recovering from the throws of persistent supply chain disruptions.

Floorplan Interest Income Fading

Part 1: Rising Interest Rates and Increasing Inventories Are Anticipated to Remove the Unlikely Profit Center

Interest rates and inventory levels remain top of mind for auto dealers. Compared to last year, interest rates have significantly increased since the Federal Reserve began raising rates in March 2022. Inventories have also improved as the industry works through its supply chain issues. These shifts in economic trends are expected to have an impact on many aspects of auto dealer operations. In this week’s post, we talk about floorplan interest income and pose some important questions: What is floorplan interest expense, and what are floorplan credits? How have floorplan credits turned into an unlikely profit center for dealers? Can we expect this trend to continue amid changing conditions?

Auto Industry Trends to Monitor in 2023

An Automotive Potpourri

January is a month to review statistics from the prior year and to make predictions for the new year. The automobile industry is no different. In this post, we tackle a potpourri of trends to monitor in 2023, including new and used vehicle prices, electric vehicles, connected cars, and SAAR predictions.

Six Things to Consider When Working with a Business Appraiser

In this post, we discuss six things that attorneys or auto dealers should consider when selecting or working with a business appraiser.

December 2022 SAAR

The December SAAR was 13.3 million units, down 5.3% from last month but up 4.7% from this time last year. This month’s SAAR data is a bit concerning for the auto industry, as supply chain improvements do not seem to be translating to improvements in vehicle sales pace as quickly as the last couple months have indicated. Over the past month, it has seemed more and more likely that plummeting trade-in equity, persistently-high interest rates, and growing fears of an economic recession are keeping the sale of automobiles low, which could spell trouble for auto dealers that have thrived in a high-price environment over the past eighteen months.

‘Twas the Blog Before Christmas…

2022 Mercer Capital Auto Dealer Holiday Poem

‘Twas the Night before Christmas, when all through the lot No vehicle was stirring, no customer ‘Bot All service lanes and lifts were empty and bare In hopes that the technicians soon would be there.Our analysts report yet another great year Despite a war in Ukraine and other big fears Record profits and operations in fixed Here we go again with allocations nixed.When most in the industry can boast of success Let’s tip our glasses in hopes ‘chips be in excess Now it’s time to ponder, look back and review To our past Blog topics that interested you.Is the industry shifting to directly sell? Will Ford follow Tesla, or only time will tell? The dealership model protected by state law; Turns out different than anyone foresaw?Many market disruptors appear on the scene How will they perform? and what does it all mean? From ride share to tall machines, ready to vend Will they be successful, or come to an end?EVs continue to dominate headlines By 2030 ICE vehicles may draw fines And will there be enough stations to charge Or will constraints on the power grid be too large.Cars are ever changing, some may even call smart Connecting infotainment and data by part Then there are vehicles and sports of power Gaining popularity hour by hour.Now Penske! Now Sonic! Auto Nation, Group 1! Gupta, Smoke, other researchers join in the fun To listen by quarter to each earnings call Will Q4 be the one where revenues fall?Each passing month reports production by the SAAR Wondering where have we been; where we currently are How it all translates to multiples so high Best to be explained by metric called Blue Sky.Then events bring industry and sport together Just as the calendar, ever changing weather From the recent World Cup to upcoming ‘Bowl Advertisers, teams will be ready to roll.Wishing you joyful season with merry and glee We will be blogging again in 2023 Mercer Auto Team will now fade out of sight Merry Christmas to all, and to all good night!

November 2022 SAAR

The November 2022 SAAR was 14.1 million units, down 6.5% from last month but up 7.9% from November 2021. Compared to this time last year, vehicle availability has significantly improved, and there seems to be hope around the industry that the auto inventory crunch is in its final act. If true, this would be good news for auto dealers and consumers alike, as more units on dealer lots seem to be the first step in a “return to normal” for the industry. While it’s clear that a year-over-year improvement is present, a dip from last month’s SAAR figure may raise red flags for some of our readers. However, an additional selling weekend in October and a marginal uptick in sales due to natural disasters in the Gulf of Mexico were both tailwinds that supported a surprising improvement in the SAAR last month. Given this perspective, November 2022’s SAAR seems to return to the larger trend of improving conditions.On a full-year basis, this month’s SAAR moved the 2022 average from 13.76 million units at the end of last month to 13.79 million units, a relative drop in the bucket. Even if another improvement in the industry’s sales pace follows suit in December, it’s clear that a full-year SAAR of fewer than 14 million units is almost inevitable. Unadjusted sales trends on a relative basis are in line with the last several months. November 2022 unadjusted sales are noticeably better than November 2021 but remain depressed compared to November 2015 through 2020. It’s likely that the gap between the pre-pandemic sales pace and the current sales pace will continue to narrow in 2023, but the rate at which improvements are expected throughout the next year remains unclear. As we have learned over the past two and a half years, no one truly knows what to expect regarding geopolitical events and OEM decision-making that impact inventory availability and consumers’ demand for automobiles. Simply put, expectations for the next year of selling should be cautiously optimistic.InventoryAs we mentioned earlier in this blog, it’s clear that inventory conditions are improving. According to the NADA, inventory on the ground reached 1.65 million units in November, which is up 6.5% from last month and 57% from last year. We believe it’s likely that nationwide auto inventories will remain roughly flat through the end of 2022, with continuing marginal improvements expected throughout 2023. The industry’s inventory-to-sales ratio, a metric released with a one-month lag, actually fell in October 2022 due to a significant improvement in last month’s sales pace (as elevated sales outran inventory production over the month). Going forward, we believe that a return to the long-run average inventory-to-sales ratio of 2.41x is very unlikely in the near term or throughout 2023. Given how auto dealer profitability has thrived in the low-inventory environment, we find it increasingly likely that a fundamental shift in the industry has already occurred. What if auto dealers never return to the days of 2-3x monthly sales worth of inventory on the lot? The last two years have informed us that dealers can thrive in this environment, but only time will tell us how sustainable this success may or may not be, particularly considering how profits are split between dealers and OEMs.Transaction Prices, Monthly Payments, and Incentive SpendingAccording to J.D. Power, November 2022’s average transaction price is expected to reach $45,872, 3.1% higher than this time last year. While 3.1% doesn’t seem egregiously high in this period of high inflation, we’d note that this is in addition to much higher prices from two years ago with no signs of meaningful price declines. The only way to know if prices will contract will be to wait for a complete recovery of nationwide inventory levels and the satisfaction of any pent-up demand that may still be lingering in the industry.Alongside sticker prices, another affordability metric is the industry’s average monthly payment. In November 2022, the average monthly payment is expected to be $712, an increase of $48 from last year. A few factors determine the average monthly payment made by consumers: 1.) the transaction price, 2.) the agreed-upon interest rate, and 3.) the term of the loan.While we have already made it clear that transaction prices continue to increase, it is notable that interest rates continue to grow as well. The Federal Reserve raised the federal funds rate for the fourth consecutive time in November 2022, bringing the overnight lending rate to its highest point since 2008 and elevating all interest rates throughout the economy. According to Experian’s State of the Automotive Finance Market Q3 2022 Report, the average auto loan rate in Q3 2022 was 5.16% (compared to 4.09% last year and 4.23% in 2020). Term lengths on auto loans, the final piece of the monthly payment puzzle, typically range from 12 to 84 months. According to Experian’s report, the average term of auto loans originated in Q3 2022 was 69.73 months, trending toward the 72-month mark and largely in line with the past two years (69.51 in 2021 and 69.64 in 2020). According to Edmunds, the share of auto loans exceeding 73-month terms increased from 27% in October 2017 to 34% in October 2022.Average incentive spending per unit is expected to total $1,009 in November 2022, down 35% from this time last year. Despite being down year over year, this month marks the end of a six-month streak where average incentive spending per unit remained below $1,000. Perhaps OEMs are beginning to relent and offer more incentives as spending across the economy cools off.December 2022 OutlookMercer Capital’s outlook for the December 2022 SAAR is optimistic. Industry supply chain conditions are improving. However, sales volumes will likely continue to be closely tied to production volumes, although less so than a few months ago. High profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Consumer activity may begin to cool off as affordability becomes an issue for many prospective buyers, but at this point, we have to see it to believe it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The Top 2022 Blog Posts from Auto Dealer Valuation Insights

Despite existing operational and new economic headwinds in 2022, auto dealers continued to produce record profits. As we wind down the year and look towards next year, we look back to see what was popular with you—our loyal readers. These are your favorite posts of 2022, which all highlight opportunities or threats to the traditional auto dealership.Future of Auto Dealerships In this blog post, David Harkins discussed the inventory challenges dealers continued to face in 2022. David also posed the question: would prevailing supply conditions fundamentally change the franchise dealer model? After reviewing the history of the franchised dealer network in the United States, David highlighted the concept of direct selling. We have definitely seen some shift to direct selling with some manufacturers more so than others, mostly with their Electric Vehicles (EVs).Succession Planning Just as our recent World Cup post paired an auto dealer topic to sports, Scott Womack paired auto dealer succession planning to the NCAA March Madness tournament. This post explained some of the key considerations for business valuations in connection with succession planning in a March Madness-style bracket. Succession planning continues to be top of mind for aging dealers as they identify the next generation of owners within their immediate or extended families.Rideshare: Friend or Foe to Auto Dealers and Manufacturers The current batch of threats to the auto dealerships' success seemed to center around the adoption of EVs and the continued development of autonomous vehicles. A few short years ago, the newest/biggest threat to auto dealers was thought to be rideshare. In this post, Harrison Holt presented the anticipated effects of ridesharing on the auto industry, along with the resulting shift from the pandemic. While we expect rideshare to continue coexisting with auto dealers, the industry has proven that it can survive and flourish despite these outside threats.SmartConnected Cars, OTAs, and Their Impact on Auto Dealers No, we weren’t commenting on the compact, fuel-efficient design models resulting from the discontinued venture between Swatch and Mercedes-Benz. We were referring to connected cars that operate like smartphones or smart appliances. In this post, Scott Womack discussed the size of the connected car market and informed our readers about Over the Air Updates (OTAs) and their ongoing connection with auto dealership service departments. Despite having disadvantages, OTAs provide some advantages and opportunities for auto dealers with new service department revenue sources.Carvana Is Looking More Like Icarus Another market disrupter to auto dealers has been Carvana. With its iconic car vending machines, Carvana attempted to reduce its real estate footprint compared to traditional auto dealerships. The company initially stood out with its online-first presence to capture digital sales. In this post, David Harkins discussed Carvana’s strategies to scale its business platform and its most recent challenges and struggles. Along the way, the Carvana narrative provided several key takeaways for auto dealers to capitalize on consumer-centric shifts in the car buying space.Powersports: Alternative Growth Opportunity for Auto Dealers Another emerging opportunity for auto dealers with excess cash from continued profits or remaining PPP funds is an investment in powersports. Powersports franchises operate similarly to traditional auto dealerships. Auto dealers with the skills and experience to sell high volumes of automobiles would also possess the necessary skills to succeed in the powersports industry. In this post, Scott Womack educates readers on the powersports industry, including the similarities and differences to traditional auto dealerships. More of our dealership clients continue to add alternative investments in powersports franchises adjacent to their existing markets.ConclusionWe look forward to 2023 and appreciate your interest in our Valuation Insights blog. We will round out the year with the final SAAR blog post and another installment of our ‘Twas the Blog Before Christmas,” highlighting the past year in the auto dealer industry. May you and your family enjoy a happy holiday season and a prosperous new year!

Auto Brands and the 2022 World Cup

Who Are the Top Ranked Countries?

After failing to qualify in 2018, the United States Men’s National Soccer Team went over 3,000 days between World Cup matches. After returning to the World Cup stage this year, the U.S. team notched draws against Wales and England, meaning that the U.S. will advance to the knockout stages if they win against Iran.In the spirit of the Cup, we compare the FIFA rankings of the world’s largest vehicle-producing countries. Spoiler alert: there is no correlation. But in our research, we found plenty of interesting nuggets. We also discuss top vehicle-producing nations that did not qualify for the World Cup and nations that did but do not have a significant presence in auto production. We also get into brand presence and Blue Sky multiples of these nations’ vehicle brands.FIFA Rankings, World Cup Groups, and Vehicle Production DataAs the industry’s supply chain issues have shown us in 2022, the world economy is interconnected. Both the World Cup and personal vehicles demonstrate a wide variety of cultures and consumer preferences. Vehicle production data in this piece is based on depressed 2022 levels reported by the International Organization of Motor Vehicle Manufacturers, or "OICA." We note this data may not perfectly illustrate nuances between manufacturing vs. assembly. For example, none of the top 10 most popular vehicle brands in Brazil in 2021 were actually Brazilian, which ranks 6th globally in population as well as car production.The table below shows all 32 countries in the World Cup that are also captured in the reported 37 largest global auto producers for 2022. Only Brazil and Spain are ranked in the top 10 of both categories, with reigning World Cup champion France producing the 12th most cars in 2022 according to OICA. Germany is also ranked highly in soccer and car production, coming in 5th in cars produced and 11th in the World FIFA Rankings.The “Group of Death”In world soccer, the "Group of Death" refers to which group looks to be the most difficult to advance to the knockout stages. With the expanded tournament and group determination based on FIFA rankings, the odds of a prohibitive favorite being in the same group as two other favorites are significantly reduced. However, the Russian invasion of Ukraine meant the last three spots had not been determined at the time of the drawing. These three spots, eventually won by Wales, Australia, and Costa Rica, were placed into Pot 4 despite their FIFA rankings. This led to Group B having teams currently ranked 5, 16, 19, and 20, or a sum of 60. The next toughest World Cup group in terms of combined FIFA ranking is Group E with Spain, Germany, Japan, and Costa Rica. In terms of vehicle production, this would certainly be the Group of Death with three of the top seven vehicle-producing countries. When you consider that China (FIFA 79) and India (FIFA 106) are two of these, that’s some heavy concentration in Group E. Group A is the only group that does not have one of the world’s largest auto-producing countries.Top Vehicle Producers That Missed Out on the World Cup Now that we have looked at World Cup participant nations’ auto production industries let’s look at nations that did not qualify. While China and India have no significant soccer history, some high-level soccer teams are also top car producers, including Russia, the Czech Republic, Slovakia, Turkey, and Italy. See the table "Other Top Car Producers" for the OICA rankings of the nations that missed out on this year’s contest in Qatar. Russia hosted the 2018 World Cup and advanced to the knockout stages but was disqualified from the 2022 tournament given the ongoing conflict with Ukraine, who failed to qualify after a 0-1 loss to Wales (which was delayed due to the war). Perhaps the biggest shock to the casual observer is the omission of Italy, who won the World Cup in 2006 and the European Championships in 2020. A poor showing in the notoriously difficult European qualifying process ended for Italy after a shocking loss to tiny North Macedonia, who went on to lose to Portugal in the playoff.World Cup Teams That Do Not Produce Many AutomobilesAs noted previously, no teams from Group A are considered top auto producers. Based on geography, each of the six World Cup confederations has at least one World Cup participant without significant auto production. Costa Rica is the only country from CONCACAF (North and Central America) omitted from the OICA list though it is a relatively short distance from Mexico. Conversely, Morocco is the only African team on the top producer list. Strictly by these rankings, both Spain (7) and Morocco (22) are equally capable of playing professional soccer and producing vehicles.Auto Brands by CountryShifting away from production, there are four countries with brands that have a significant presence in the U.S.: Japan, the U.S., Germany, and South Korea. While German vehicles are associated with luxury, Japanese vehicles are viewed as more durable. German dealerships tend to fetch higher Blue Sky multiples in the U.S., but there’s an interesting comparison with their soccer teams here. While Germany is a favored high performer, Japan is viewed as more durable. Perhaps this is how Japan came from behind in the 2-1 upset when it looked like Germany might run away with it at halftime last Wednesday.Brands by country are shown below. Other major brands in the U.S. are Jaguar/Land Rover and Volvo, which are from the U.K. and Sweden, respectively.Auto Brands by OEM and Blue SkyBelow, we’ve tabulated major brands in the U.S. market, sorted by Blue Sky value according to the Q3 Haig report. We’ve included the OEM for each brand and their home country. While Acura is Honda’s luxury brand, it was first launched in the U.S. and Canada in 1986 and is primarily based in North America today. In 1989, Toyota and Nissan responded by launching Lexus and Infiniti, respectively. Other OEMs with multiple dealerships brands in the U.S. market include:VW (Audi is a luxury offering acquired in the 1960s)GM (Cadillac is a luxury offering acquired in 1908)Hyundai (also owns Kia; neither of which are considered luxury)Ford (Lincoln is a luxury offering acquired in 1922) While Toyota has become one of the most desirable dealership brands, they are still deemed less valuable than Lexus dealerships. Audis have declined from their runup in popularity about ten years ago, but they remain considerably more valuable than their VW counterpart, who continues to climb out of its emissions scandal. While Blue Sky multiples are positively correlated to luxury brands compared to the domestic/mass market, Cadillac, Infiniti, and Lincoln are all less valuable than the mass market version offered by their OEMs. According to Haig’s Blue Sky multiples, Cadillac is below all GM brands (Chevy and Buick-GMC), Infiniti is below Nissan, and Lincoln is below Ford. Whether it’s an issue of product mix or lack of attention/investment compared to core brands, there’s a clear dichotomy in performance compared to Lexus and Audi.ConclusionWhile we would have liked to run a statistical model based on brand desirability or production, we know the correlation would be spurious at best. But that won’t stop us from cheering on the boys in red, white, and blue!Mercer Capital follows key trends in the auto industry to stay current with the operating environment of our privately held auto dealer clients. To see how prevailing trends may impact your dealership, contact a Mercer Capital professional today.

Meet the Team

Harrison Holt

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Harrison Holt, Financial Analyst.Harrison Holt began his valuation career at Mercer Capital as an intern in the summer of 2019. After finishing his degree at Rhodes College in 2020, Harrison joined Mercer Capital as a financial analyst in the Memphis office. In 2022, he moved to Mercer Capital’s Nashville office.What influenced you to pursue a career at Mercer Capital?Harrison Holt: I have always been very intrigued and excited by math, problem-solving, and storytelling. Luckily for me, valuation work is the intersection of the underlying story behind a business's performance and the value indications that established financial models imply for that business. These two forces have to reconcile with one another, and I really enjoy telling the stories of numerous businesses through my valuation work. Each valuation engagement is unique and offers many specific research and learning opportunities. My work with auto dealerships has been the most rewarding, as I have the opportunity to consistently study the auto dealer industry for market insights that pertain to various valuations. Location is also a huge benefit of working for Mercer Capital. As a native Tennessean hailing from Jackson, starting my career in West Tennessee was a great way to stay close to family and challenge myself professionally. After my recent move from the Memphis office to the Nashville office, I feel grateful that I can do the type of work that I love in a part of the country that I love.What types of auto engagements have you worked on?Harrison Holt: There are many reasons an auto dealership would need a valuation from Mercer. For example, divorce proceedings, estate planning, and buy-sell issues are a few of the reasons why an auto dealership has crossed my desk. In my valuation work, I have valued dealer operations, entities that own the underlying dealership real estate, and powersports dealerships.Tell me about any interesting takeaways from your experience writing the monthly SAAR blog.Harrison Holt: Starting my career at the beginning of the COVID-19 pandemic came with its fair share of challenges, and this was especially true for the automotive industry. I have followed the monthly Bureau of Economic Analysis (BEA) SAAR data releases for two consecutive years now. When I first started studying the SAAR, I became very comfortable with the data set as a whole. I started by reviewing the industry's history so that I could draw relevant conclusions about where automotive retail stands today. As most of our readers know, the last two years have been a roller coaster for auto dealers and the broader economy. When I first began covering the industry, high inventory volumes and low selling activity were the auto dealerships' challenges. Mere months later, low inventory balances and red-hot demand pushed sticker prices and profitability through the roof. Supply chain issues, pent-up demand, and a volatile affordability environment have made following the industry exciting. While it's been challenging to keep up, I am grateful that it's an intriguing story to tell.What has surprised you the most about valuing auto dealerships compared to businesses in other industries?Harrison Holt: From time to time, I have found myself asking questions like “How can a dealership with only twenty units on the lot sustain record profitability over so many consecutive months?” and “Does it make sense to sell this dealership at elevated earnings and elevated blue sky multiples when the business itself is a premier cash flowing asset?”. These questions come from observing the situation in which most of our clients find themselves. It has been nice to see how well these clients are doing, especially when many other industries are struggling to adapt to a rapidly changing economic environment. While client success is always good to see, valuing auto dealerships in the current environment does not come without challenges. One challenge I have encountered while valuing auto dealerships has been estimating ongoing performance, which is a crucial step in the valuation process. Dealership performance over the past two years has been encouraging for our clients, but estimating the ongoing earning power of their dealerships into the future requires us to temper our expectations from currently elevated levels. The industry as a whole has addressed this issue by changing the standard for calculating ongoing earnings used in deal pricing. Prior to the pandemic, trailing twelve-month earnings were the standard. Since then, industry participants such as Haig Partners have suggested multiple iterations of how to calculate ongoing earnings in an attempt to:Exclude the initially uncertain COVID-19 impact,Partially consider elevated earnings but place more weight pre-COVID performance, andPlace more reliance on recent outperformance due to COVID and the chip shortage. Now approaching three years since the pandemic began, it is increasingly difficult to derive a one-size-fits-all formula for how to determine ongoing earnings for all the 16,000+ dealerships across the country.

October 2022 SAAR

The October 2022 SAAR was 14.9 million units, up 12.7% from October 2021 and up 9.8% from last month. This month’s SAAR comes as a bit of a surprise, as the last three months’ sales pace settled at around 13.4 million units and seemed to have stabilized at a short-term equilibrium. However, meaningful improvements in inventory balances and other tailwinds like natural disaster-related demand contributed to the second-highest monthly SAAR total this year. For perspective, from 2014-2019, there were zero months where SAAR was below this recent high in the inventory-constrained 2022.On a full-year basis, this month’s SAAR moved the 2022 average SAAR from 13.6 million units at the end of last month to 13.73 million units. Despite this turning of the tide, it remains unlikely that the full-year 2022 SAAR will exceed 14 million units, as there is not much time left in the year to pull the average up above that threshold. For perspective, the November and December SAAR would need to average 15.4 million units for the full-year average to arrive at 14 million units. Furthermore, as auto sales are a function of both supply and demand, it will also be interesting to keep an eye on the demand side of the auto sales equation as recessionary fears intensify. Stay tuned over the next two months to see if the national sales pace continues to improve.Unadjusted sales trends on a relative basis are mainly in line with the last several months. October 2022 unadjusted sales are markedly better than October 2021 but remain depressed when compared to October 2015 through 2020. However, the gap between current sales and what was observed prior to the auto inventory crunch seems to be shrinking as the months go by, which is also an interesting trend to keep an eye on as 2022 winds down.Total Sales - Not Seasonally AdjustedInventoryAccording to the NADA, ground and transit inventory totaled 1.54 million units at the end of October 2022. The industry has not seen this magnitude of inventory flow since May 2021, which is right around when the industry’s inventory crunch began to take hold. In our opinion, we should hesitate before assuming that vehicle availability has fully recovered, as the September 2022 industry inventory-to-sales ratio (0.64x) remains well below its long-run average (2.4x). We will get a better idea of this month’s inventory levels when October 2022 I/S ratio data is released next month. Nevertheless, improved inventory balances are a good sign for consumers and dealers alike, as it seems like it has been ages since the days of full car lots and numerous options for consumers to test drive and choose from.Inventory/SalesTransaction Prices, Incentive Spending, and Monthly PaymentsAccording to J.D. Power, the average transaction price of a new vehicle is expected to be $45,599 in October 2022. After numerous months of increasing transaction prices and new record highs each month, this month’s average transaction price is roughly flat compared to September 2022. Rising interest rates and recessionary fears have cooled transaction activity in many areas of the economy, like the housing market and the mergers and acquisitions market, and we believe it is likely that the same trend will occur with respect to new vehicle purchases over the next several months. Keep in mind that these activities heavily rely on interest rates to support affordable pricing. For dealers, new vehicle prices are still so elevated that profitability can still be achieved at lower volumes. Still, many dealers should expect sticker prices to begin to slip modestly in an effort to keep monthly payments in a reasonable range for consumers. According to J.D. Power, average incentive spending per unit is expected to total $882, down 44.7% from this time last year and marking the sixth straight month below $1,000. It is clear that OEMs are sticking to their guns and keeping incentives low, and we believe that this is likely to continue as long as GPUs remain historically high. However, incentives could creep back up for OEMs and dealers to keep transaction prices higher as consumers have become increasingly accustomed to these rising prices.Hurricane Ian’s Effect On the Automotive IndustryHurricane Ian raked a path of destruction across the southeast United States on September 28, 2022, devastating the state of Florida and its Gulf Coast before making final landfall in South Carolina two days later. The hurricane is now considered the second-deadliest storm to strike the continental United States since Hurricane Katrina in 2005.While the total damage done to the Gulf Coast and its people goes far beyond its effects on the automotive industry, some interesting auto-related effects are worth mentioning to our blog readers.According to Cox Automotive, it has been estimated that the total number of severely damaged vehicles in need of replacement range anywhere from 30,000 to 70,000 as a result of Hurricane Ian. Considering the region’s significant demand for replacement vehicles, retail sales in the affected area are expected to increase in the fourth quarter of 2022. Perhaps the uptick in sales that the entire industry experienced in October has something to do with this acute regional demand.Cox Automotive also posits that about 80% of replacement vehicles will come from the used vehicle market due to difficulties acquiring new vehicles from dealerships. This demand for used vehicles is likely to apply upward pressure on regional pricing and make it more likely that flood-damaged vehicles appear for sale. Generally, totaled cars and trucks are given a “salvage title” and cannot be legally driven in the United States. However, some states allow buyers to repair totaled vehicles and issue a “rebuilt title,” making them legal to drive. This process will likely produce fraudulently “title-washed” vehicles as opportunists can purchase a totaled car or truck at auction, move them to a state where re-titling is legal, and return the car to the Gulf to resell.In any case, filling the void that Hurricane Ian left in the vehicle market should prove difficult in a time of inventory restrictions. While inventory balances seem to be improving on a macro level, a concentrated need in Florida and South Carolina will likely be challenging to fill. Dealers in the region should conduct thorough due diligence on used vehicles they purchase for resale and expect demand to remain elevated throughout the hurricane recovery process.November 2022 OutlookMercer Capital’s outlook for the November 2022 SAAR is cautiously optimistic. Industry supply chain conditions are beginning to improve. However, sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving despite recent signs of improvement. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the November SAAR can continue to approach 15 million units and signal a true turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

Market Insights on Auto Dealer M&A Activity

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss the current state of the M&A market and other timely trends in the auto dealer industry. Specifically, I wanted to discuss some of the movements in Blue Sky multiples for various franchises and interpret the range of multiples that Haig Partners recently published with the release of their Second Quarter 2022 Haig Report (subscription required).What is the current state of the M&A market for auto dealerships? Any signs of transactions slowing down? Are you seeing earnings or multiples start to plateau or revert?Kevin: The market continues to be quite active, with a nice balance of buyers focused on strategic growth opportunities and sellers who see valuations still at or near peak levels. The pandemic accelerated the need for scale to effectively compete in a changing retail environment—consumers are ever more focused on a seamless buying experience and are embracing a digital world for researching, negotiating, and transacting the retail purchase. Couple that with the benefits of marketing a broad and large selection of inventory and dealers recognize they need more franchises and locations to effectively compete.Our analysis indicates there may be over 8 million units of pent-up demand in the marketplaceNADA has suspended the publication of data on the performance of the total dealer body, but public company financial results do indicate we may have seen a plateau in earnings. Based on our analysis, the average public dealership earned $7.0M through the Last Twelve Months (LTM) ended 2Q 2022, down just slightly from $7.1M for the quarter ended 1Q 2022. However, that’s still up approximately $5M from 2019’s average of $2.1M!! From the data and research we are seeing, inventory constraints should continue for the next several years and ensure the dealer enjoys strong gross margins for some time. Our analysis indicates there may be over 8 million units of pent-up demand in the marketplace. Additionally, the high gross F&I and service departments continue to see an upward trajectory in results.As for multiples, our firm tracks this very closely by monitoring transactions we represent alongside ongoing discussions with industry leaders in finance, accounting, and the legal communities. In summary, multiples overall have changed little since the pandemic: it’s the underlying earnings that have contributed to the elevated valuations. That said, some franchises are gaining traction and are more appealing to buyers. These include Toyota, Hyundai/Kia, and Stellantis.Scott: With NADA’s suspension of dealership performance data, Mercer Capital has also pivoted to supplying information and trends from public companies in our recently published Mid-Year 2022 newsletter. Despite positive revenue growth in the last twelve and six months, revenue growth in the more recent period is less in all six public companies showing signs of slowing down. Additionally, public companies have continued to enjoy heightened gross profit from new and used vehicle departments compared to historical averages.Any new trends in buy/sell negotiations in the last few months? Any sticking points?Kevin: There really haven’t been any “new” issues that have arisen in buy/sell negotiations, but one trend we are seeing both in the industry and our practice is a willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise.The willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise is a recent trendSellers are seeing these alternatives as additional strategic options for their families and organizations. In some cases, a seller may choose to take some proverbial chips off the table by exiting a market or selling a couple of stores. Further, as outside capital investors continue to target auto retail due to strong and consistent returns, some dealers are selling a percentage of the business, which allows them to stay on and operate the business. Our recent publications have gone into greater detail on this subject if readers want to know more about this trend.Scott: The trend for dealers to sell a small minority stake in their entire group (or perhaps only divest of a rooftop or two) seems to be a new and interesting phenomenon. This trend appears to be a shift from dealers selling the entire enterprise or a majority stake in the dealership holdings. Auto dealers clearly value maintaining control and not having to answer to a family office group, private equity holders, or a third-party controlling stakeholder.Operating an auto dealership is very much a day-to-day and month-to-month business. Auto dealers are usually heavily invested in their communities and care deeply about their legacies.Selling a minority interest gives the auto dealer some liquidity. While dealerships have become very valuable and have generated record profits, often those profits are reinvested in the business or are leveraged against other assets, while the heightened value of the dealership only represents value on paper until a transaction or liquidation event occurs.Mercer Capital provides estate planning valuation services that may benefit owners who take some chips off the table once a firm like Haig Partners has helped them negotiate a minority investment.The latest Haig Report mentions Toyota is the most desirable brand. Is there any reason it would not obtain the same multiple as luxury brands?Kevin: It’s no surprise to anyone active in the auto retail space that Toyota dealerships are in high demand. Manufacturer relations are best in class, and the underlying product continues to resonate with consumers. Our firm has sold 33 Toyota dealerships, including the 2nd highest-valued dealership ever in August 2022 (John Elway’s Crown Toyota). Buyer interest is always substantial. In most cases, Toyota stores will bring better multiples than some of the smaller luxury makes like Jaguar, Land Rover, and Audi. But in general, the high-profile luxury nameplates still command a higher multiple. There are a number of reasons, but the most impactful cause is there are far fewer Lexus, Mercedes-Benz, or BMW dealerships in the market and even fewer for sale. So “Economics 101” is in play—limited supply and high demand bring higher multiples. Scott: Kevin’s comparison of a Toyota dealership investment to a luxury brand is equivalent to the allure of owning a professional sports franchise. Interested investors in luxury brands covet the exclusivity and market appeal of owning one of these franchises. There may only be a few luxury brands in each market, and if one becomes available, it may be a long time until another luxury franchise becomes available. To Kevin’s point, the approximate number of Toyota and various luxury brand franchises in the United States are as follows: Will the shift for Cadillac, Infiniti, and Lincoln blue sky from a dollar amount to a multiple materially shift the value of these franchises?Kevin: Over the past several years, several weaker franchises traded for a hard dollar amount rather than a multiple of earnings, given the lack of repeatable earnings. Buyers placed a value on the “shingle” and looked at used cars and fixed operations as their way to make money from these stores. However, as some of these brands have seen a resurgence in performance, partially from the post-pandemic bump but also from developing more appealing products, we have seen buyers take a more bullish approach. So, yes, these franchises have definitely seen an improvement in value. Nissan is another brand we have seen improve in the eyes of buyers. The franchise still has a way to go, but many believe the worst is behind Nissan — their products are solid, and the OEM has learned from its “volume at all costs” approach.Are there any new threats to the auto industry?Kevin: Open any automotive periodical, and you will see discussions about the potential impact of EVs. One consequence of the forecasted shift away from ICE to EV is the desire of some OEMs to modify their retail strategies. Tesla and other EV startups have gone the direct selling route, foregoing the traditional franchise model, and some major manufacturers are eyeing this strategy with jealousy. All despite historically failed attempts to replicate the proven ability of the franchise retailer to best serve the consumer’s needs. Ford, Hyundai, Mercedes-Benz, Volvo, and Polestar are examples of manufacturers who are overtly or quietly trying to change the retail model more toward the agency model seen in Europe. Haig Partners encourages dealers to be active participants with their state dealer associations to ensure franchise laws remain robust and protective of retailers. Scott: Despite the news and headlines dominated by EVs, the implications of EVs can vary drastically by brand. In other words, some OEMs are further along in producing EV models, while others do not anticipate producing EVs before 2024 and 2025. Additionally, the requirements of the various OEMs to auto dealers are also quite different. Some brands do not require any additional dealer commitments, while others, such as Ford, are forcing auto dealers to declare at what level they want to opt-in for selling EVs. Ford’s financial requirements can range from $0 for dealers that do not opt-in to selling EVs (only selling ICE vehicles) to $1,200,000 for dealers that opt-in to selling EVs at the premium level.What are the typical adjustments seen in negotiations for buy/sells?Kevin: One of the most important aspects of representing a seller is ensuring the buyer has a solid understanding of the historic and expected cash flows generated by the dealership. Just looking at the dealership’s financial statement doesn’t accurately depict the earnings opportunity of the store.Just looking at the dealership financial statement doesn’t accurately depict the earnings opportunity of the storeWe extensively analyze the dealership to understand what add-backs and deducts should be applied to reflect recurring cash flow. Some are non-cash entries; others are one-time expenses or income that should be adjusted.Some common add-backs are LIFO expenses, owner’s compensation (if excessive and/or not to be recurring for a future owner), owner’s perks that run through the statement (travel, airplane, etc.), and F&I over-remits/mailbox money that is generated outside the dealer statement.Deductions to earnings include PPP funds and one-time settlement funds or gains from asset sales.Scott: Similarly, Mercer Capital reviews the balance sheets of auto dealers for potential adjustments to inventories, fixed assets, working capital, goodwill, non-operating assets, and owner accounts receivable. Some typical areas for potential adjustments on the income statement include inventories, owner compensation, rent, other income, owner perquisites, and remittance, to which Kevin refers.Remittance is related to the service contract and other warranty-related products the dealership offers in connection with the purchase of a vehicle. A dealer can act as an agent in this process by offering products from multiple third-party vendors or acting as the principal, whereby they own a reinsurance company that offers those products to their customers. In either case, the dealership retains a portion of the service contract or warranty product and remits the other portion to the obligor or administrator of the contract. In an example where a vehicle service contract is $800, the dealership might retain $400, report that as income, and remit $400 to the obligor/administrator.In some cases, the dealer may have an “overpayment” arrangement in place with the third-party administrator or their reinsurance company, whereby the dealer might retain $250 in the previous example and then remit $550 to the obligor/administrator. The “overpayment” arrangement allows the dealership to determine the amount of the overpayment and designate a beneficiary outside the dealership to receive the overpayment amount. These arrangements effectively reduce or shift income out of the dealership. The presence and amounts of overpayments or over remittances should be considered as potential normalization adjustments to earnings when determining the value of a dealership.We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Mid-Year 2022 Auto Dealer Industry Newsletter Release

We are pleased to release our Mid-Year 2022 Auto Dealer Industry Newsletter after taking a brief hiatus.Beginning in the fall of last year, NADA suspended publication of its Dealership Profile data which was a helpful resource to industry participants and to our industry newsletter. We have pivoted by providing additional data from the public auto dealer groups, which we hope you will find insightful.Recurring Trends and What They Mean to YouThe first half of 2022 continued to present challenges to auto dealers. Once again, auto dealers have proven their resilience and adaptability to continue operating at heightened profitability.Recurring trends such as a lack of new vehicle supply and a shortage of microchips persist, while new challenges such as inflation, rising interest rates, and increasing gas prices began to emerge. We highlight and discuss these trends and provide key industry metrics, including total retailer profit per unit on new vehicles, supply of new vehicles on dealer’s lots, the average age of new cars, average trade-in equity on used vehicles, and fleet sales.Additionally, we recap the second quarter earnings calls of public auto companies, which further touch on these trends.Blue Sky Multiples Have Jumped for SomeAlso included in this newsletter is a discussion of blue sky multiples across various franchise segments, including luxury dealerships, mid-line dealerships, and domestic dealerships.While most blue sky multiples have remained flat for the last several quarters, there are interesting discussions on their application between buyers and sellers during continued periods of heightened earnings. Several franchises have seen their blue sky multiples jump after a period of stagnant value.What the Publics Can Tell UsFinally, this newsletter provides financial data and metrics from public auto companies that we believe are informative to single-point or smaller private auto dealers. Specifically, we analyze the market capitalization, dealership count, gross profit by segment, and the implied blue sky multiples from public earnings data for the second quarter of 2022 and the prior year-end 2021.What Other Topics Would You Like to Know More About?We hope you find this newsletter to be a helpful resource and appreciate any feedback along with way. Please send suggested content topics or ideas that you’d like to see in future editions to Mercer Capital’s Auto Dealer Industry Group Leader, Scott A. Womack, ASA, MAFF, at womacks@mercercapital.com. Click the link below to download this latest issueValue Focus: Auto Dealer IndustryDownload the Mid-Year 2022 Newsletter

Regulatory Update: Amendments to FTC Safeguards Rule

Impacts to Auto Dealerships

Over the last month, the Mercer Capital Auto Team attended several October meetings with the Tennessee Automotive Association. The featured presentation by ComplyAuto discussed the features of the Federal Trade Commission’s (“FTC”) Safeguard Rule (“Safeguards Rule” or “Rule”) and the amendments with which must be complied by early December 2022. In previous posts, we have discussed advancements in auto retailing and vehicles and how added technology brings added risks to cybersecurity and the protection of customer information. This post discusses the FTC Safeguards Rule and what auto dealers and their advisors need to know.What Is the FTC’s Safeguards Rule?The official title of the Safeguards Rule is “Standards for Safeguarding Customer Information.” The original Rule took effect in 2003 and was intended to ensure that entities covered under the Rule maintained safeguards to protect the security of customer information. Few changes were made to the Rule since 2003 until the FTC’s proposed amendments in December 2021. These amendments sought to make changes to the original Rule to keep up with advancements and changes in technology. More importantly, qualified businesses must comply with the FTC’s Safeguards Rule by December 9, 2022.Why Does the FTC Safeguards Rule Impact Auto Dealerships?The Safeguards Rule applies to financial institutions subject to the FTC’s jurisdiction that are not subject to the enforcement of a separate authority or regulator under Section 505 of the Graham-Leach-Bliley Act. Further, the Rule defines a financial institution as “any institution of business of which is engaging in an activity that is financial in nature or incidental to such financial activities.” While on the face, this appears to be speaking primarily about banks or other similar financial institutions, Section 314.2(h) explicitly cites auto dealerships as an example of a financial institution given the nature of its leased and purchased transactions and participation in the financing activities of the transactions.NADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards RuleNADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards Rule, with additional ongoing costs in the neighborhood of $277,000 annually. These numbers may seem staggering at first, but what are the costs of not complying? The NADA estimates the average fine for a violation under the Rule is $47,000. While this number appears steep, it is also unclear how the FTC would view a security breach. In other words, if a security breach compromised the personal/financial information of multiple consumers, would that be one violation, or would each consumer breached be a separate violation? If the latter occurs, fines could quickly escalate into the high six digits for a more significant volume breach. This ambiguity makes it more impactful for dealerships that might otherwise “risk” the possibility of a $47,000 fine compared to annual costs of $277,000, not to mention the upfront costs.The Safeguards Rule is meant to work in tandem with consumer privacy rights and policies enforced by state attorneys general and the FTC. All 50 states have enacted some state cybersecurity requirements to protect data breach laws, with some instituting specific cybersecurity laws.What Are the Guidelines Under the FTC Safeguards Rule?Rule 1 – Four Written PoliciesAuto dealers are required to adopt, maintain, and adhere to four written policies: data retention plan, incident response plan, information security plan, and IT change management procedures. These policies must be written and the appropriate size as it relates to the complexity of your auto dealership business, the nature and scope of your business activities, and the sensitivity of the information in issue. These written policies should aim to ensure the security and confidentiality of customer information, protect against anticipated threats or hazards to the security and integrity of that information, and protect against unauthorized access to information that could lead to substantial harm or inconvenience to any customer. To comply with the information security plan, auto dealerships should have a designated/qualified individual to implement and supervise the company’s information security program.Rule 2 – Annual Risk Assessment On an annual basis, auto dealerships must complete a formal risk assessment to determine foreseeable risks and threats – both internally and externally – to protect customers’ information security, confidentiality, and integrity. Compliant assessments will also document attempts to mitigate these threats and any updates to the four written policies in Rule #1 resulting from items discovered during the annual risk assessment.Rule 3 – Annual Employee Security Awareness TrainingAn auto dealership’s security program is only as effective as its least vigilant staff member. All employees must be trained on overall awareness as well as the specific components of your information security program, policies, procedures, and safeguards. Further, the Rule insists on specialized training for those employees, affiliates, and providers with hands-on responsibility for carrying out your dealership’s information security program.Rule 4 – Phishing and Social Engineering SimulationsAs part of the new amendments, the FTC Rule requires dealerships to test their employee’s susceptibility to social engineering and phishing scams. In other words, how likely are your employees to fall for these phishing scams? Would regular testing and simulations give the dealer principal an idea of how easily or frequently these threats could become reality? Hopefully, regular simulations would also raise employees’ awareness that such threats exist daily.Rule 5 – Service Provider ContractsDuring a lease or purchase transaction, auto dealerships may require service providers that access non-public personal information (“NPI”) to sign a specific contract whereby they also promise to adopt and adhere to reasonable safeguards. Dealers will want to establish or work with pre-vetted contracts signed by their vendors and must be mindful of built-in e-sign functionality to increase efficiency with vendors.Rule 6 – Annual Service Provider and Risk AssessmentsDealers must select service providers with the skills and experience to maintain appropriate safeguards. Under the Rule, dealers are actually required to assess and monitor their service providers for continued adequacy of safeguards, even when that can often be accomplished through a security questionnaire or checklist. Dealers should consider periodic reassessments of their service providers to ensure safeguards are maintained.Rule 7 – Annual Penetration Test and Bi-Annual Vulnerability ScansDealers are required to perform annual internal penetration testing of their networks to simulate internal and external hacking. To comply with the Rule, they must also perform biannual vulnerability assessments for known exploits. As part of the total ongoing costs estimated earlier in this blog, NADA estimates that the average cost of an annual penetration test is $23,000. This cost could be increased by the number of individual rooftops that a particular dealer owns, which could rise significantly for bigger private auto groups. In addition, dealers should test whenever there are material changes to their operations or business arrangements or when they know circumstances may have occurred that could have a material impact on their information security system.Rule 8 – Device, Data & Systems InventoryDealers are required to perform a regular inventory of their data and systems. Inventory procedures would include identifying all data in their possession, tracking where the data is collected and by which vendor and system, and understanding how the data is stored and transmitted. Has your dealership added a new server? Because systems, networks, and operations like this constantly change, an auto dealer’s safeguards cannot remain static.Rule 9 – Annual Report to the Board of DirectorsAuto dealers must submit a regular written report to the Board of Directors or governing body. If your dealership does not have a Board of Directors, the report must go to a senior officer responsible for the information security program. Ideally, the report would be written and delivered by the qualified individual established to run your information security program in Rule #1. The report should include the overall assessment of your dealership’s compliance with its information security program and would discuss test results and responses to threats, including any amendments or changes to the dealership’s written policies.What Additional Guidelines Does the Rule Require Concerning Advanced Cybersecurity and Device Protection?Rule 10 – Intrusion and Attack DetectionFTC Safeguards Rule, along with most OEMs and cybersecurity insurance carriers, will require that dealers have an established system to detect intrusions and attacks on your network.Rule 11 – User and Employee Monitoring and LoggingDealers must have a security system that restricts how users and employees log into and use their information security system. Dealers must be able to detect who is on the system at all times while detecting and preventing unauthorized access, sharing, use of, and tampering with customer information.Rule 12 – Device EncryptionThroughout auto dealerships’ operations, employees utilize devices such as laptops, tablets, and mobile devices–all of which contain customer information. The Rule requires that the hard drives of each of these devices be encrypted. However, compliance with these terms can become complicated with the increase of remote employees and remotely-enabled devices.Rule 13 – Multi-Factor Authentication (“MFAs”)Dealers must implement multi-factor authentication on any system used to access customer information, including device-level MFAs. Specifically, the Rule requires at least two of these authentication factors: a knowledge factor (such as a password) and an inherence factor (such as biometric characteristics like a fingerprint, facial features, face recognition, etc.).ConclusionsThe clock is ticking for auto dealers unaware of the FTC's new amendments to the Safeguards Rule and the compliance deadline of December 9, 2022. With changes to existing and emerging technology, protecting private/confidential consumer information becomes more critical. Cybersecurity and hacking threats seem to multiply every day. Could your dealership be next? Have you taken the necessary steps to bolster your information security programs? If your auto dealership is not compliant with the FTC's Safeguards Rule, seek a professional vendor to assist you in this area.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

September 2022 SAAR

The September SAAR was 13.5 million units, up 2.3% from last month and up 9.6% from September 2021, when the industry had less than one million vehicles available for sale. While this month’s SAAR highlights a year-over-year improvement and gives us context around how low inventory managed to fall in 2021, this month’s data release does not indicate a “return to normal” by any means. The Q3 2022 SAAR averaged 13.3 million units, roughly flat with Q2 2022’s average and consistent with the last three months of the industry’s sales pace, indicating no fundamental changes. Looking at the 2022 SAAR as a whole, the previous three months of this year have displayed stability at around 13.0 million units, while the first six months of the year were significantly more volatile.Looking at unadjusted sales numbers, September 2022 also showed a real improvement from this time last year. While this month’s unadjusted sales (1.16 million units) were certainly still limited by supply-side inventory issues and much lower than sales levels observed from 2015-2020, it is clear that September 2021 (1.05 million units) was a low point that makes the last month look good by comparison. See the chart below for unadjusted sales numbers from the previous eight September releases:InventoryOn the supply side of the vehicle sales equation, inventories have remained low but seem to be marginally improving. The industry inventory to sales (“I/S”) ratio was 0.67x in August, the most recently available month of data. August’s I/S ratio compares to 0.51x in July and an average of 0.47x from January 2022 to July 2022. For the remainder of the year, we expect industry-wide inventory levels to slowly improve. However, it is unclear how long auto manufacturers will take to bring the industry I/S ratio up to the long-run average of 2.4x. As this recovery unfolds, it will be important to keep an eye on efforts to bring more domestic semiconductor facilities online, the ongoing status of the war in eastern Europe, and the availability of key inputs from Asian markets like China. These underlying factors are key levers that would allow the domestic production of vehicles to improve in a meaningful way.Transaction Prices, Incentive Spending, and Monthly PaymentsTransaction prices remained at near-record levels in September. According to J.D. Power, the average new vehicle transaction price is projected to reach $45,622 this month, a 10.3% increase from this time last year and the fourth highest average transaction price ever. In terms of monthly payments made by consumers, rising interest rates on elevated sticker prices drive monthly payments up to an average of $667 per consumer. Incentive spending by OEMs has remained low in September. The average incentive spending per unit was $936 this month, down 47.8% from this time last year and the fifth straight month of sub-$1000 spending per unit.Is Pent-Up Demand Still Present in the Auto Industry?The sales pace of any industry is a function of a two-sided equation that includes both demand and supply. The first major factor in this equation is demand, which has been considered very high, even “pent-up,” over the last year and a half in most of the industry’s analytical publications (including some of our blogs). We recently tried to quantify pent-up demand in our June 2022 SAAR blog. In this June publication, we wanted to start a conversation around pent-up demand by challenging the idea that sales would suddenly return to 17 million units once the supply side of the equation normalizes. The idea that sales may not return to a 17 million unit SAAR right away is centered around the idea of cyclicality.When supply is so restricted, it’s not a high bar for demand to be above supplyThe auto industry has always been cyclical, with more vehicles sold during the “good times” and fewer vehicles sold during recessionary periods and times of general economic uncertainty. Cyclicality makes sense, as consumers are less likely to make a large purchase like a home or a vehicle during uncertain times when debt is expensive, and recessionary fears are present. Put simply, we are starting to wonder if the industry as a whole has overestimated the level of pent-up demand. When supply is so restricted, it’s not a high bar for demand to be above supply. And over the past two years, with rising vehicle prices, we’ve learned that consumer demand for personal vehicles was more inelastic than previously thought. Even accepting these two premises, we believe the cyclicality of auto sales may mean that by the time inventory issues are alleviated, consumers may be less confident in purchasing new vehicles.Over the last month, the country has found itself anticipating a down cycle of the entire economy as interest rates and other measures of risk increase at a rapid pace. The housing market has cooled off, wage growth has also decelerated, and the market for new and used vehicles is likely cooling off as well. It doesn’t help that near-record transaction prices and the expensive cost of debt are making vehicle purchases more and more difficult to afford. On the Mercer Capital Auto Dealer team, we tend toward the idea that pent-up demand is dissipating or perhaps overstated. We believe that rising transaction prices are more of a function of supply-side constraints than high levels of consumer competition for available vehicles.October 2022 OutlookMercer Capital’s outlook for the October 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the October SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape. Stability at around 13.0 million units is a much more realistic expectation.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Book Review: The Future of Automotive Retail (Part 2)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

In this week’s blog, we continue our review of the excellent book, The Future of Automotive Retail by Steve Greenfield. It covers the changing trends of consumer behavior and technology that will likely continue to shape the automotive retailing experience for decades to come.In part one of this two-part series, we discussed the first part of the book, the “convenience economy,” including predictions of changes to power sources and vehicle production.This post continues to march through the book and focuses on vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the proposed future of the auto dealership.Vehicle OwnershipAs the book's author notes, trends in vehicle ownership have changed several times in the last few years alone. Historically, traditional car ownership dominated the industry, with each household directly owning one or two vehicles. Leasing has continued to provide an alternative form of access to personal vehicles, even with common pitfalls such as mileage restrictions, down payments, expensive insurance, extensive fees, and difficulty exiting the lease. In some instances, these disadvantages have made leasing more complicated and costly than traditional ownership.The proliferation of upstart rideshares such as Uber and Lyft provided additional alternatives to vehicle ownership. Rideshares were supposed to reduce the number of vehicles on the road, reducing traffic as consumers could be paired up with strangers heading in the same direction. While rideshares have disrupted taxis, not enough people are willing or interested in taking a taxi to work every day. The pandemic also caused the pendulum to shift back to direct ownership as fewer people were traveling and commuting, public events were limited, and fears of germs and contamination led consumers to prefer the safety of their own vehicles.Through both undercurrents, subscription services have always existed. The book notes that many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownership. In fact, a study by McKinsey predicts that at least 20% of all new and used car retail sales will be in the form of a subscription as soon as 2025.Many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownershipWhat is a car subscription service? Car subscription services contain similar elements as long-term rentals or short-term leases. Subscription services offer the use of the vehicle for one all-inclusive monthly fee that typically includes repair & maintenance, insurance, taxes, licenses, and registration, leaving owners/drivers responsible for gas. One limitation with subscription services is that most packages have mileage limits, much like traditional car leases.What is the value proposition of a car subscription? A vehicle subscription allows consumers to switch vehicles easily and frequently with varying minimum periods, some as short as one month. Are you in a market where it would be appealing to have an SUV for winter conditions but a sedan for commuting during the other moderate seasons throughout the year? The myth behind this value proposition is that most customers retain their current vehicle for an average of 10 - 18 months, according to the CPO for Faaren, an upstart subscription company.However, consumers value the ability to bundle car insurance, service, and occasionally finance in certain subscription packages. The convenience economy is also a factor here, as consumers can experience different vehicle features while enjoying affordable subscription services for around $300 to $500 for small to mid-sized cars. While the upfront monthly cost is likely higher than direct ownership, it comes with more price assurances. Consumers with a subscription service wouldn’t have surprise maintenance bills when their car stops working, and some consumers will likely value not having to worry about such repairs.Another challenge to car subscription services is the demographic of likely consumers. As we discussed last week, the prevalence of the convenience economy is primarily attributed to millennials. Younger consumers are dissuaded from car subscription services because they are unable to find insurance at affordable rates. In contrast, baby boomers, who can obtain car insurance for reasonable rates, are more comfortable with the traditional vehicle ownership market, which might explain why car subscriptions have struggled to gain momentum.Another final challenge to subscription services is depreciation. Most readers understand that a vehicle loses value immediately after driving off the dealership lot. On average, a vehicle depreciates approximately 20% in the first year of ownership, and by the end of year five, a vehicle is generally worth about 40% of its initial value, according to Edmunds. With car subscriptions being shorter in duration, how do companies price in the lost value due to depreciation in the first three years of a car’s life span? Hertz is attempting to bridge this gap by pricing subscriptions in the $999 - $1,399 range to account for depreciation. Only time will tell if consumers will have an appetite for subscription packages at these higher prices.AutonomyJust as the Jetsons and Back to the Future 2 predicted, autonomous vehicles are on the horizon for the auto industry. Perhaps, autonomous taxis will gain popularity before individuals own autonomous vehicles. The auto industry believed autonomous vehicles would come sooner than what has actually materialized. Why have consumers been slower to adopt autonomous vehicles? One primary value proposition for autonomous vehicles is safety. Based on average statistics in the United States, a collision occurs every 500,000 miles, with a fatality occurring every 60 million miles. While that may seem remote, these statistics translate to approximately 1.5 million fatalities on roadways each year worldwide.A large percentage of consumers are not comfortable riding in autonomous vehicles and prefer to continue driving their own cars. They would like to see increased safety precautions and widely support a congressional mandate requiring the installation of manual brakes in self-driving cars.Let’s examine the levels of autonomous vehicles per the book:Level 0 – No Automation – Human driver fully operates the vehicle; added features such as backup cameras or blind spot indicators; this level represents most of the vehicles currently on the road;Level 1 – Driver Assistance – Characterized as having at least one driver-support system involving either braking, steering, or acceleration;Level 2 – Partial Automation – The vehicle can take over steering, acceleration, or braking, but the driver must remain behind the wheel and ready to take action;Level 3 – Conditional-DrivingAutomation – Drivers don’t have to actively steer or brake in certain situations such as a traffic jam; Vehicles monitor the driver’s state if/when they have to jump back behind the wheel;Level 4 – High-Driving Automation – No human interaction; many of these vehicles don’t have a steering wheel or pedals; This level may not work during severe weather conditions or limited visibility; currently limited in testing to specific low-speed geographies and areas;Level 5 – Full-Driving Automation – These vehicles travel anywhere and do anything; Passengers have full autonomy to enjoy entertainment, take a nap, perform work, etc.; Vehicles do not have steering wheels, pedals, or brakes; Interiors are designed more like “smart cabins”; There are currently only 1,400 autonomous vehicles on the road in the U.S.; While the timing and full adoption of Level 5 vehicles is unknown, most experts predict there will be a hybrid mix of autonomous and human drivers for at least the next thirty years. Once fully automated vehicles are integrated into the mainstream market, experts predict that dealers will sell far fewer vehicles. The sale and ownership of autonomous vehicles will be shared or part of the subscription models previously mentioned. Why subscription and shared models? Current vehicle utilization (the percentage or amount of time your car is actually in use) is somewhere in the neighborhood of only 4%. This means that 96% of the time, your car is either sitting idle at your house or in the parking garage at your office. Turo is an example of a service that allows you to list your vehicle on their platform when you’re not using it, like an “Airbnb of Cars.” Autonomous vehicles would improve upon a car-sharing model because they reduce the friction of handing off the car and the deliverer not having a ride back to where they came from. Autonomous vehicles will provide more opportunities to be fully utilized and shared by multiple individuals through subscription-based ownership. Subscription models could take on the form of monthly fees or a price-per-trip basis, like current forms of rideshare or taxi.Connected CarsWe previously wrote a post analyzing the impact of connected cars on auto dealerships. What are connected cars? In short, connected cars can communicate with other systems outside the car, allowing the car to share internet access with other devices inside and outside the car. Just as smartphones are mini-computers, smart/connected cars are also becoming mobile computers with infotainment options. The added connectivity that comes with connected cars can potentially engage the millennial generation, who has a strong affinity for smartphones. As cars morph into smartphone-like electronics, they could become a competitor for the attention of younger generations.Like smartphones and appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air Updates (“OTA”s). An OTA is a software improvement or upgrade sent directly to the vehicle from the vehicle manufacturers (or “OEM”) or industry software company through a wireless internet connection. Examples of OTAs include heated beam lights during inclement weather, changes to suspension systems, or alerts to the driver if windows, doors, or trunks have been left open.The current struggle between OEMs and auto dealers is who controls the OTAs and, more importantly, who retains the revenue. McKinsey reports that the size of the OTA revenue pool could reach $750 billion by 2030, which equates to $310 of revenue per vehicle and $180 of cost savings per vehicle. Not only could auto dealers be left out of this revenue pool, but OTA updates that occur directly will forgo/reduce the need for vehicle servicing at the dealership.ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022. That figure represents 91% of new, connected vehicles in the U.S. compared to only 51% in Asia-Pacific countries and 37% in Latin American countries. Perhaps dealers can join in the OTA revenue sharing by offering an “AppleCare” subscription for cars. Current examples are GM’s OnStar or NissanConnect, which provide services such as remote door locking, vehicle health reports, maintenance notifications, and others.Two unintended consequences of smart/connected cars will be data collection, privacy, and protection, much like smartphones. What types of data will be collected, and will the data collection be limited? The additional connectivity allows data collectors to track where the vehicle has been or even predict where the vehicle is going next. Smart or connected cars could risk being hacked, not only for customer information but also to automatically unlock a vehicle from a wireless keychain or disable the operation of a connected car. How will this be prevented, and will liability rest with the OEM or the dealer?Service and RepairsHow will all these technological and behavioral shifts impact the fixed operations of a dealership, more precisely, its parts and service department? Recall that the fixed operations department has historically represented the highest margin segment of an auto dealership’s operations. On the surface, electric vehicles, OTA updates, and autonomous vehicles could decimate a dealer’s service department. For example, electric vehicles have approximately 20 moving parts, compared to 2,000 moving parts in a traditional ICE vehicle. Fewer parts mean fewer opportunities for repairs and servicing, not to mention EVs don’t run on oil and will eliminate the need for oil changes.Fewer parts mean fewer opportunities for repairs and servicingThe book describes the onset of EVs as the “Blockbuster” moment for Jiffy Lube, whose core operations have revolved around oil changes. Jiffy Lube’s shift to potentially adding charging stations and other services should serve as an example to auto dealers to avoid their “Blockbuster” moment. The stark reality is that the shift to EVs would eliminate approximately 41% of Jiffy Lube’s core services and render another 18% to a lower level of importance.How can auto dealerships respond to these challenges, and what other opportunities might present themselves? EVs are not all doom and gloom, as previously described. One underreported characteristic of EVs is that they are much heavier than their ICE counterparts. The additional weight provides two opportunities for auto dealers: EVs will wear out tires 30% faster than ICE vehicles, leading to higher purchases of tires, and collisions involving EVs will cause more significant damage, leading to higher-priced repairs at the body shop. Simple parts, like windshields, are much more complicated in EVs, and consumers will be more apt to trust a reliable service department at a dealership to reinstall a smart windshield than a local repair shop. In the future, dealers could leverage that consumer trust to add options like battery swaps and sensor calibrations.As autonomous vehicles become more prominent, dealers could provide other services like late-night cleaning, car washes, or middle-of-the-night repairs. These added services could help dealers get a higher market share of fixed operation work while reducing the need for loaner vehicles if the car could transport itself to the dealership for these maintenance items. Until then, dealers can also offer remote or driveway repair services, including delivery and pick-up services, to compete with Lithia and others. Dealers could participate in the increased tire sales and potentially offer tire subscriptions to EV owners.Finally, revenue from EV recalls may be more lucrative than initially reported. EV recalls will involve more expensive parts such as batteries, which can comprise nearly 40% of the EVs total cost. According to the U.S. National Highway Traffic Safety Administration, about one out of every four vehicles on the road are open to a recall. Higher EV recalls provide auto dealers with two revenue-boosting opportunities: 1) OEMs generally pay for the recall work, and 2) service technicians can diagnose problems and recommend additional service items when the vehicle is in the shop.Future of the Auto DealershipAuto dealers have navigated numerous challenges throughout their history and the last few years. The next five, ten, twenty, and thirty years appear to be continual challenges brought about by technology and shifting behavioral trends. Historically, auto dealers have focused on day-to-day operations: how many cars have I sold today, this week, this month? A majority of the systems and processes have also been manual, as certain functions don’t directly communicate with each other. Auto dealers must also fight the stigma that they are among the least trusted professionals among consumers, with nurses and medical doctors ranking on the other end of the spectrum.The central perspective to point out from the book is that the future of auto dealers is not all doom and gloom. There are plenty of growth opportunities on the horizon, but the key is to adapt and plan for those shifts in advance to avoid their own “Blockbuster” moments. At a recent auto presentation, I heard a motivational speaker use a quote that I think is fitting for today’s auto dealers: “so what, now what…”. Dealers should adopt this attitude while facing a growing market of EVs, autonomous vehicles, OTA updates, etc., and seek service offerings and solutions that will appeal to consumers in the coming years.We highly recommend The Future of Automotive Retail to anyone in the auto dealer space. You will both enjoy the book and learn from it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Reach out to a Mercer Capital auto dealer team member to learn more about the value of your dealership.

Book Review: The Future of Automotive Retail (Part 1)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

As fall approaches and school is back in swing, the Auto Team has completed our summer reading. Over the next two posts, we review the book The Future of Automotive Retail by Steve Greenfield. This book discusses changes in trends of consumer behavior and technology that will likely continue to shape the auto dealer retailing experience for decades to come. Additionally, the book makes numerous predictions about when and how those changes can pose both opportunities and challenges for auto dealerships. In our review, we discuss the content, trends, and predictions found in the book (and add a few of our own upon occasion).The auto industry has adapted to numerous changes just in the last few years alone: the introduction/proliferation of electric vehicles, online or partially online transactions of new and used vehicles, shortages in new vehicle production caused by the pandemic and microchip crisis, and threats of direct sales from the manufacturer to the consumer directly, to name a few. Moving forward, the auto industry seems to be on the precipice of change as it relates to these shifts and also evolving technology that will impact the ownership of automobiles in the future.Regarding predictions of changes to technology impacting the auto industry, we can look to the big and small screen, specifically, the Jetsons and Back to the Future 2. This iconic cartoon and movie gave us a glimpse of life in the 21st century. The Jetson’s debuted in the 1960s, and while no specific year was ever referenced, trailers for the original series mention that the setting is 100 years in the future, or approximately 2060. In fact, George Jetson’s birthday was just a couple of months ago, according to some fans. Avid viewers of the show will recall that the cartoon correctly predicted many technological advances that have already occurred today or are just on the horizon – video calls, robotic vacuums, tablet computers, robots, flying cars, smart watches, drones, 3D printed food, and flat screen TVs. In Back to the Future 2, Marty McFly travels into the future to the year 2015 where we see technological advances such as drones, tablet computers with mobile payment options, waste fueled cars, flying cars, and robotic/autonomous taxis to name a few.In part one of this blog series, we review the discussions and predictions caused by the “convenience economy,” including changes to power sources and vehicle production. In next week’s post, we will discuss vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the overall future of the auto dealership.Just as auto dealers have proven their resiliency and adaptability to challenges over the last two years caused by the pandemic, they must continue to be aware of oncoming changes to technology and the retail model to stay competitive and not get left behind.Convenience EconomyWhat is the convenience economy? Per the book, the convenience economy is all about consumer empowerment and control. Today’s consumers expect to be able to purchase and receive whatever they want, whenever they want, and however they want. Some credit (or blame) the shift to a convenience economy to millennials. However, the lion’s share of the shift can be traced back to market disruption. Market disruption, in this sense, refers to new service offerings or companies that cause a profound change in the existing business landscape in a particular industry that forces existing businesses to undergo significant transformation to stay competitive. Common examples of market disruption include:Netflix’s impact on video consumption and the shift to streaming services that forced Blockbuster out of business.Uber/Lyft’s impact on getting a ride displacing taxis if not car ownership altogether as initially proffered.Amazon’s impact on ordering and delivering consumer products online. Amazon is most cited for the shift to a convenience economy and referred to as the “Amazon effect.” The auto industry is also not immune to market disruption. Examples include Tesla’s impact on the introduction and popularity of electric cars as well as a shift to direct sales to customers, Carvana and Vroom’s impact on the way vehicles are purchased and delivered, and Lithia’s Driveway impact to mobile servicing and repair.In the convenience economy, today’s consumer places value on convenience over priceIn the convenience economy, today’s consumer places value on convenience over price. Historically, the convenience economy affected lower priced consumer goods. In recent years, the convenience economy is also shifting to higher priced goods, such as the purchase of an automobile. According to the book, research predicts that 80% of all car deals in urban markets will include some components of digital retail elements in the next five years, eschewing the old-school haggling process at a dealership.Auto dealers have responded by adding digital elements to the transaction process to meet the demands of today’s consumer. According to Cox Automotive, this short list of digital changes also allows for dealers to operate more efficiently:Reducing the time that customers spend at the dealershipReducing the number of steps to complete a transactionReduction of time dealership staff spend on completing a transactionFewer staff required to complete a transaction The shift to the digital retail experience doesn’t totally eliminate the physical dealership experience. A study by Deloitte indicates the following reasons why some consumers would not want to completely shift to an online purchase:Ability to see the vehicle before purchaseAbility to test drive the vehiclePreference to negotiate in personDon’t feel comfortable purchasing online In contrast, the same study lists the following as advantages listed by consumers for online components to an auto transaction:ConvenienceSpeedEase of UseNecessityAbility to avoid going to a dealershipHow Should Auto Dealers React to the Convenience Economy?Auto dealers should recognize that they are in another period of market disruption. In an effort to meet consumer demands, auto dealers should continue to offer and improve digital elements to the transaction process. This shift could also present downsizing opportunities for the auto dealership facilities and footprint, as the need for over-the-top showrooms may be less desired by the consumer. Of course, the latter will continue to be a debate and negotiation between an auto dealer and their manufacturer.Power SourcesOf all the headlines in the auto industry in recent years, electric vehicles (EVs) continue to dominate. As discussed earlier, Tesla was an early market disrupter in this area, along with other recent start-ups like Rivian and NIO that have also joined the trend. Additionally, the legacy manufacturers of internal combustion engine (“ICE”) automobiles have also been producing electric vehicles with more models on the way. Auto manufacturers are also seeking to restore the balance of power regarding the profit margins on new vehicle sales, which have shifted to the dealers in the last year and a half or so. Several manufacturers such as Ford, Buick, and Volkswagen have expressed a desire to alter the traditional state franchise law system of the dealer network and explore direct sales models to consumers. We will discuss this trend in more detail in next week’s blog.E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehiclesMcKinsey & Company estimates that EVs will comprise more than half of all U.S. passenger car transactions by 2030 if the early adoption momentum continues. Recently, California passed a mandate requiring all new car sales by 2035 to be free of greenhouse gas, aka a mandate pushing EVs.Like the convenience economy, millennials are also being credited with driving the EV movement. E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehicles. A study by OC&C Strategy cited the four main concerns that consumers are apprehensive about choosing an EV:RangePriceCharging AvailabilitySpeed of Charging Earlier, we discussed a theme in the book stating that millennials valued convenience over price in the emerging convenience economy. Apparently, there is a limit to the perceived value of convenience with regard to purchasing an EV. The same study by OC&C Strategy discovered that only 16% of consumers polled would be willing to pay $2,500 more for an EV over an ICE vehicle, while 70% would not pay more than a $500 premium for an EV. It’s important to remember that convenience works both ways. While consumers may prefer quicker buying transactions, which many have associated with EVs, they may give back that time and then some awaiting their vehicle to charge as compared to refilling a gas tank.What Alternatives are Being Developed to Relieve Consumer Anxiety Related to Charging Availability?In addition to other federal and state mandates calling for the build-out and development of charging station infrastructure, NIO is also developing a battery swap technology in other countries that might eventually lead to adoption in the U.S. NIO has sold approximately 120,000 EVs to date and has erected 300 battery swapping stations across China. These stations completed 500,000 battery swaps in 2020, and NIO is currently expanding the operation to Norway. Why Norway? Norway has enacted some of the most aggressive legislation against ICE vehicles, charging a 20% carbon tax on those vehicles. The results speak for themselves: 65% of all new cars sold in Norway in 2021 were EVs, up from 54% in 2020 and 42% in 2019.We will discuss the disruptive nature of EVs on an auto dealer’s parts and service operation in next week’s blog.While EVs have fewer moving parts than their ICE counterparts, there are a couple of underreported qualities of EVs that could present opportunities for a dealer’s fixed operations.Another unintended consequence of the EV movement is the further reliance on China for various components in the EV supply chain. We have covered some of this topic in a prior blog. According to Benchmark Mineral Intelligence, China comprises the following in the EV supply chain:80% of the world’s total output of raw materials for advanced batteries90% of rare metals, alloys, and magnets8 out of 14 of the largest cobalt mines are located in the Congo, all of which are Chinese controlled>60% of the world’s graphite, an essential raw material in electric batteries Another important consideration is infrastructure. If the adoption of EVs continues, can the existing power grid support the added demand for charging these vehicles? While most believe utility companies have plenty of bandwidth to handle the extra load, some prognosticators point to the winter storm that besieged Texas in 2021 as evidence to the contrary. If nothing else, that storm and the resulting fallout should serve as a cautionary reminder that upgrades to existing grid infrastructure will be necessary and will not come cheaply. We further note that consumers in California have been urged to not charge their vehicles amid a heat wave. Other items to consider with EVs are as follows:Charging Time – currently, most battery ranges top out at approximately 300 miles; the fastest charging technology takes 40 minutes to charge to an approximate 80% level.Pollution – Part of the value proposition of EVs is to reduce the greenhouse gas effect of ICE vehicles. One unanswered question is how/where will the disposal of batteries take place at scale, and will there be environmental harm caused by that disposal? Some experts just see it as a shift of pollution in urban areas where ICE vehicles are currently operated to battery production/disposal sites in more rural areas.Used EVs transparency – As the EV movement continues to evolve and more used EVs hit the market, how will the consumer be able to discern how much battery life is remaining on the current battery before it will need to be replaced, which is a material ongoing cost with EVs?Margin Compression – If dealers will be allowed to sell and participate in the margins on new EV transactions, how will compressed margins impact the dealers' bottom line (especially in lieu of heightened margins in the last couple of years)? Many of the legacy auto manufacturers are currently selling EVs at a loss which does not provide much incentive to auto dealers.Vehicle ProductionThe vehicle production model has changed dramatically in the last three years because of the impact of the pandemic, followed by the microchip shortage and resulting supply chain issues. As a result, auto manufacturers and auto dealers have grown accustomed to operating with less inventory. Both have thrived in the short term, but how will vehicle production be impacted in the future as ICE and EVs continue to coexist for at least another few decades?The convenience economy shows up again with vehicle production. Consumers want total choice over the trim package, color, features, engine size, infotainment, and other components of their vehicles. This priority has been a struggle for consumers with lower levels of production and inventory over the last few years. As the book highlights, American consumers are not willing to wait weeks/months for customized vehicles in the convenience economy, sacrificing choice for convenience and showing that preferences can be dynamic.How will manufacturers handle vehicle production going forward in a system that most believe will maintain lower inventory levels? Historically, auto manufacturers have relied on crude data to form production decisions. If the manufacturers could anticipate the wishes of their consumers, they could save money by not overproducing the wrong model of cars or by shipping a preset number of vehicles/models to the wrong market. According to Cox Automotive, auto manufacturers and auto dealers need to focus on 12% of vehicle combinations that ultimately comprise 75% of the sales. Further, JD Power estimates that approximately 88% of manufacturers’ combinations sell fewer than fifty units each and account for only 25% of net sales. The consumer and the statistics say it all….give the people what they want.According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030Another technology advancement that could impact vehicle production is 3D printing. Just as the Jetsons predicted 3D printed food, 3D technology is now capable of printing an entire vehicle. Local Motors has focused on a project to 3D print an autonomous electric shuttle called Olli. With current technology, the Olli takes nearly 10 hours to 3D print and is not cost efficient. Perhaps the shorter-term adaptation for 3D printing in the auto industry will be on replacement parts, particularly for later date models where it becomes less economically viable for dealers to hold a significant inventory of these parts.Finally, how will the ongoing impact of the microchip shortage affect the auto industry? We all learned just how important and how many microchips are involved in new vehicle parts and production in the last two years. According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030, representing a 5X increase in their proportion in 2019. EVs will only add to the demand for microchips in the years to come. In a previous blog, we highlighted the timeline and costs involved with building new microchip plants in the U.S. to attempt to relieve some of the ongoing demand.ConclusionAuto dealers have proven that they are an adaptive, resilient bunch; able to navigate the challenges in the economy and consumer behavior in the last few years. Today we seem to be at a crossroads of emerging technology and continual changes to consumer behavior that will impact the future of auto retail. Just as past market disruptions have proven, auto dealers that are resistant to change might be left behind.I attended an auto meeting this week, and one participant made the remark that the auto industry has seen more change in the last five years than the previous 25 and more change in the last two years than the previous five. In part two of the blog next week, we will continue to explore these changes and the potential challenges and opportunities facing auto deals in the coming years.In the meantime, we highly recommend The Future of Automotive Retail for anyone in the auto dealer industry. Readers will be both educated and entertained.Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Blue Sky Multiples Remain Flat as Earnings Plateau

Dealers Continue to Perform through Negative Economic Indicators

The first half of 2022 was tumultuous, which Haig Partners succinctly summarized in their Q2 Haig Report. Negative headlines and headwinds aplenty:Inflation driving up costs for dealers and reducing affordability for customersInterest rates rising also drives up dealer costs and reduces affordabilityGas prices spiked (and are receding) which also reduces affordability (though this has only indirect impact on dealer costs)The stock market (as measured by the S&P 500) is down 18.2% year to date and GDP growth has been negative for two consecutive quartersThere is geopolitical uncertainty surrounding China-Taiwan and Russia's invasion of UkraineSupply chain issues have plagued the industry for over a year and a half and consumers are well aware of the high transaction prices of vehicles Available monthly data for these economic indicators are displayed since December 2019 in the following graphs below. In spite of these conditions, dealers have navigated this environment to deliver record profits. However, Haig points to the public dealers' earnings in Q2 as an indication that dealer earnings may have plateaued. The future direction of profitability is hard to predict, but with all the historical indicators for the industry flashing red, eventually, even the supply-demand imbalance cannot overcome all of these challenges. Whenever supply starts to rebound, the key question will be the degree to which gross profitability reverts as well.Blue Sky Multiples – Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range in the next seven quarters. However, after years of only reporting a value range due to a lack of profitability, Cadillac dealerships reported at a range of 3x-4x in Q4 2021. Similarly, Infiniti and Lincoln reported a multiple range of 3x-4x in the Q2 2022. Value ranges are used instead of multiples when many of the brands' dealers are not profitable, but with improved earnings performance industry-wide, Haig is now reporting a multiple range for every brand covered in its report for the first time since at least Diesel Gate in 2014. We note the 3x-4x range for Cadillac, Infiniti, and Lincoln matches the 3x-4x range of Acura dealerships, which have consistently reported a multiple range at the low end for luxury dealerships.Blue Sky Multiples – Mid-Line Import BrandsDuring the first half of 2022, Hyundai and Kia saw another 0.25x improvement in multiple to a range of 4x-5x, building on a 0.5x improvement in Q3 2021. There are now three distinct tiers of mid-line brands: Toyota paces the top group (followed by Honda and Subaru), Hyundai and Kia, despite improvements, are still 2.0x below the top three, followed by VW, Nissan, and Mazda, which are about 1.0x below Hyundai and Kia and in line with the lowest multiples of the luxury brands.Toyota dealerships still fetch higher valuations than Audi and Jaguar-Land Rover dealerships. While they don't sell luxury vehicles, Toyotas are viewed as dependable vehicles. Potentially more important to dealers, Toyota has indicated it has no plans to replace dealerships with an agency model and is committed to a phased transition into EVs while also offering ICE vehicles and hybrids. Haig declared that Toyota might be the most desired brand in the industry. We find this interesting as Toyota dealerships remain a bargain in terms of Blue Sky's multiple range as compared to the top-of-the-line luxury dealerships. Desirability may also be factoring in cost, and the supply of luxury dealerships for sale may have an impact on the higher multiples for Porsche, Lexus, etc., particularly considering Toyota Motor Corporation owns Lexus.Blue Sky Multiples - Domestic BrandsDomestic franchise multiples have not changed since Q3 2020. With the rise of Hyundai and Kia's multiples over the past year, domestic brands' multiples are now generally in between the second and third tier of mid-line imports, where they once held a slight advantage over some of those brands. One would think that supply chain constraints would more negatively impact import brands than their domestic counterparts. However, the past two years have demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last four years, domestic brands Ford, Chevrolet and Buick-GMC are the only brands across all of the published Haig multiples that have decreased. In Q2 2018, these brands' multiples were half a turn higher than they are in Q2 2022. Stellantis actually increased over that same period but only by 0.25x.It is important to note that the published blue-sky multiple ranges, while certainly reasonable, do not imply that dealerships are actually transacting at these multiples. With the performance of most dealerships remaining elevated, owners on the lower end of Blue Sky multiples are less likely to transact when the payback period on an investment is so short unless they need liquidity or are approaching retirement without an identified succession plan.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don't directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

August 2022 SAAR

The August SAAR was 13.2 million units, down 1.1% from last month but up 0.7% from August 2021. This month’s data release marks the third month in a row that the SAAR has been in the low 13 million-unit range, with the metric seemingly having stabilized in the short term. To illustrate this trend, the average SAAR has been 13.1 million units over the last four months.Now that the August data has been released and two-thirds of the year is a known commodity, we have much more visibility to what the full year SAAR might look like. Year to date average SAAR is 13.7 million units, which makes it even harder for us to imagine a full year SAAR over 14 million units. To put numbers in a hypothetical scenario, the turnaround that is necessary to reach an average SAAR of 14 million units in 2022 would require the next four months’ SAAR to average 14.7 million units.Unadjusted sales numbers have also kept with the trends we have seen over the last several months. Comparing the previous eight August’s unadjusted sales figures (in the chart below) emphasizes the longevity of the production issues that have gripped the auto industry. In August 2020, unadjusted sales had begun to recover from the steep drop that started in April 2020 in response to the COVID-19 pandemic. While this recovery seemed strong in late 2020 and into the first half of 2021, supply chain issues reared their ugly head during the summer of 2021 and, by August of last year, had completely stagnated. While August 2022’s unadjusted sales show a modest recovery from this time last year, it is clear that the auto industry is still very much in the midst of an inventory crisis.InventorySpeaking of inventory levels, not much has changed since the last time the data was released. Industry-wide inventory balances for July came in at 0.50x, down from June’s figure of 0.56x. The inventory to sales ratio has been under 1.0x since May 2021 and had been climbing the past few months to the highest levels since August 2021 before declining in July 2022 (most recently available inventory data tends to lag by a month).To put context to this ratio, on average, dealers have been selling twice the number of vehicles that are on their lots during the last several months. Consumers have had to get accustomed to pre-ordering vehicles or simply settling for the vehicle that just so happens to be on the lot when they visit a dealership. Pent-up demand for these vehicles has not had a chance to unwind at all, and the most likely scenario that dealerships can expect is that pent-up demand will hang around until meaningful changes in inventory availability come to fruition (when that actually might happen is still a mystery). See the chart below for a look at the industry’s inventory to sales ratio from January 2020 through July 2022.Transaction Prices, Incentive Spending, and Monthly PaymentsFor our weekly readers, it may seem like there has been a new record for the average transaction price set almost every month over the past year, and that is not far from the truth. According to J.D. Power, the average transaction price for a vehicle in August was $46,259, up 11.5% from this time last year and the highest average transaction price on record. Inventory constraints have continued to push prices higher and higher each month, but these constraints are not the only driver of vehicle prices record-setting rise. For example, OEMs have had to prioritize high-demand vehicles like trucks, SUVs and crossovers, all of which are much more expensive than the typical sedan. We believe this is particularly notable in light of elevated gas prices, which, at least in theory, should temper demand for larger vehicles that guzzle more gas.OEMs have also kept incentive spending low. In August, average incentive spending per unit is expected to total $969, a decline of 47.1% from this time last year and the fourth straight month under $1,000. Higher prices, reduced incentives and rising interest rates are also pushing average monthly payments higher. For example, the average monthly payment on a new vehicle contract reached a new record of $716 in August. As interest rates are expected to continue to rise at the Federal Reserve’s next meeting on September 20th, it is unlikely that average monthly payments will decline any time soon.Imports and ExportsImports and exports are not something that we typically touch on in our monthly SAAR blog, but supply chain issues and persistently low inventory levels have raised questions related to the international flow of vehicles. Mexico and Canada are the two primary importers of vehicles into the U.S. due largely to continental trade agreements (NAFTA and USMCA). The chart below shows the flow of vehicles (in thousands) from August 2019 through June 2022, the most recently available month of data. Like automotive retail generally, import activity is seasonal. Later in the winter season is when import activity typically slows down, and the summer and fall are when imports ramp up. Over the last two years since August 2020, seasonality has been present, but the total number of imports, on average, has fallen. For Mexican imports, the average number of vehicles imported from January 2016 to December 2019 was 105,000 per month compared to an average of 72,000 from January 2020 to June 2022. Canadian imports have followed a similar but more drastic trend, averaging 95,000 imports from 2016-2019 compared to 45,500 from 2019 to June 2022. Exports from U.S. have fallen as well, which makes sense. Producers in the country have retained more vehicles to service domestic markets instead of sending units overseas. From January 2016 to December 2019, an average of 105,000 vehicles were exported to international markets. From January 2020 to June 2022, that number fell to 78,500 vehicles per month. See the chart below for auto unit exports from August 2019 through June 2022. From looking at the raw import/export numbers, it is clear that the flow of vehicles across international lines has soften considerably. Globalization of the automotive manufacturing industry has been clawed back during this period of uncertainty and is unlikely to return to pre-pandemic levels until supply chains recover and inventories are replenished domestically and abroad. It will be interesting to follow import and export activity when inventory balances begin to recover to see how much the import/export recovery lags behind. The import/export ratio steadily declined to a recent low of 1.42x in 2021. While this figure represents a low dating back to 1993 (first published data), the supply chain constraints may only exacerbate a secular trend as this ratio was 1.66x in 2019 and 2020. Imports from Canada and Mexico were below 1.4 million for the first time since 2009 and are just above 1993 levels. While 2021 exports are down 21.1% since 2019, this actually represents a 10.9% recovery from 2020’s reduced export levels. While imports from North American trade partners are nearly the same as over 25 years ago, exports have nearly doubled.September 2022 OutlookMercer Capital’s outlook for the September 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors, of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the September SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape. We first need to get back to a monthly SAAR of 14 million.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Rideshare: Friend or Foe to Auto Dealers and Manufacturers?

Fifteen years ago, the term “ridesharing” did not exist. There were taxi and coaching services across the country, but ridesharing as an industry emerged in the late 2000s. It changed how people could “catch a ride” when using a personal vehicle was problematic or not a good decision (For example: driving after a night of drinking alcohol or when the rider is not old enough to drive).Ridesharing differs from taxi services in a couple of ways, the most notable difference being the “network effect.” Taxi services are, or at least were for the most part, city-specific, and the network effect that rideshare applications developed made it so that consumers could download one application and have access to a ride in almost every major city across the country. While many companies may call themselves things like the “Uber of X”, an early pitch deck for Uber called it the “NetJets of car services.”While taxi displacement is core to Uber’s rideshare operations, it’s called rideshare, not taxi replacement, because a key tenet of Uber's pitch was to reduce emissions by allowing strangers to carpool. In theory, this would structurally reduce the number of vehicles on the road, a major potential threat to auto dealers. Individuals could turn on a ridesharing application on their mobile phone while on the way somewhere and make a few extra dollars by picking others up and taking them to their destination as well. While this convention certainly caught on and was to the liking of environmentalists, there was another impact that the creators of ridesharing might not have seen coming, the rise of the “gig economy.” The gig economy propelled ridesharing into the stratosphere by giving people a way to work on their own time and using their own resources, namely their personal vehicles.As mentioned previously, the crux of the rideshare strategy was pitched as reducing the number of vehicles on the road, with Uber replacing taxis and also doubling as personal vehicles. It is important to note, however, that executives and shareholders’ goals for ridesharing companies are primarily to earn profits and expand market share, while other stakeholders may view the ridesharing industry as a means to combat climate change and shift United States’ culture away from an automobile-centric society.This “culture-shift” sentiment contradicts the common goal of auto manufacturers and auto dealers, which is to sell as many vehicles to as many consumers as possible. As the rise of mass rideshare companies took hold in the early 2010s, many players in the auto industry were left wondering what the rideshare wave would mean for auto dealerships.In this post, we focus on the impact of Uber and Lyft on the auto industry as a whole, particularly as compared to initial concerns. We address the questions: “How has the rise of rideshare giants affected the auto industry?”, “How did the COVID-19 pandemic affect ridesharing?” and “What can we expect from the rideshare industry going forward?”Expectations and Results – What Was the Anticipated Effect of Ridesharing on the Auto Industry?After Uber Technologies (founded in March 2009) and Lyft (founded in June 2012) took the main stage, some auto industry experts predicted that vehicle sales would not be heavily affected by the rise of the rideshare industry. These optimists expected regular taxis and public transportation (buses, trains, subways, etc.) would take the largest hit from these companies’ emergence. Vehicle ownership was not expected to decline in a meaningful way, as vehicles were expected to remain a staple of the United States’ culture and the economy.On the flip side of the coin, pessimists predicted that rideshare services would lead to a decline in sales volumes of automobiles as more consumers use rideshare applications in lieu of personal vehicles. To take the pessimists' outlook to the next level, many thought that fleets of autonomous vehicles would soon take over the road, eliminating the need for personal vehicles, especially in larger cities where public transportation has historically cut into consumers’ need for a car or truck.From our viewpoint, with the benefit of hindsight, it appears the optimists’ opinions were on the money. Carmakers were experiencing a record sales pace before the COVID-19 pandemic (more than five years into a world with ridesharing applications). The taxi, luxury coaching, and rental car industries were reeling, however, as rides from rideshare applications were much cheaper than these traditional operators, mostly due to aggressive pricing designed to capture market share during each company’s growth phase.From a macro perspective, auto dealers and manufacturers had to be relieved that the pain was felt elsewhere, despite taxi, coaching firms, and rental car companies' position as an important revenue source for auto dealers through fleet sales. However, fleet sales to these operators have traditionally been at much lower margins than sales of autos to individual consumers who might decide to become rideshare drivers. That shift could actually be a positive development for auto dealers.How Did the COVID-19 Pandemic Affect the Ridesharing Industry?The COVID-19 pandemic brought Uber and Lyft to a halt. In April 2020, ridership from both companies dropped between 70-80%. Both operators went into a “survive until we can thrive” mode, intending to hold out until passengers felt comfortable returning to the convenience of ridesharing. This revenue crater was not to the advantage of public transportation either, as those services saw a nearly 90% drop in ridership over the same time period. As an aside, auxiliary services like Uber Eats cushioned the pandemic’s blow on ridesharing companies (Uber Eats revenues grew more than 50% during the first quarter of 2020). This came as a result of consumers leaning into food delivery as a response to fears of being infected by the virus at the grocery store or at restaurants.The drop in ridership was accompanied by a sharp contraction in the SAAR metric, a measure of sales pace for auto dealers. The sales pace for automobiles across the country slowed to a crawl in April 2020 as dealer lots remained packed with vehicles that had very little interest from cautious and confused consumers. Not many folks were willing to make a large purchase with so much uncertainty abound, especially not the purchase of a vehicle during stay-at-home orders and the work-from-home movement.So did the pandemic change the landscape as it relates to auto dealers and the effect that ridesharing is having on the industry? We would say no. A recovery by both rideshare giants in late 2021 and into 2022 was encouraging to see for their investors, and as many of our readers know, auto dealers have seemingly been printing money in late 2021 and 2022. One industry’s success has clearly not been a bad thing for the other industry. Perhaps the pessimists mentioned earlier in this blog were wrong.What Can We Expect From Ridesharing Going Forward?Can we expect the ridesharing industry to continue to co-exist with auto dealers? Our answer is yes. The rise of Uber and Lyft has certainly impacted overall mobility. However, auto dealers have not borne the brunt of this displacement. The emergence of ridesharing has instead displaced taxis, coaching services, and rental car companies.At Mercer Capital, we follow the auto industry and adjacent industries closely 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 and litigation support engagements.

Powersports: Alternative Growth Opportunity for Auto Dealers

As we’ve written in previous posts, auto dealers have experienced heightened profitability over the last two years. For those without succession in place, the industry continues to experience a high level of M&A and transaction activity. For others interested in growing or scaling operations, bolt-on acquisitions of other franchises in similar or adjacent markets can present an attractive return.While those opportunities don’t always arise, dealers with excess cash from continued profits or remaining PPP funds have alternative investment choices. One such opportunity is entering the powersports industry through an acquisition of a powersports dealership or opening a point themselves. As one auto dealer client recently recounted to us, “if you have the skills and experience in selling high volumes of automobiles to consumers, then you have the necessary skills to also succeed in the powersports industry.”In this post, we discuss what comprises the powersports industry. We also offer some statistics about the size of the market in the United States and highlight similarities and differences to the traditional auto dealer industry.What Is the Powersports Industry?Although not as clearly defined and reported on as often as the automotive or auto dealer market, the powersports industry is a subset of motorsports which generally includes vehicles such as motorcycles, all-terrain vehicles (ATVs), snowmobiles, personal watercrafts, scooters and other alternative vehicles. According to IBIS World, the size of the powersports and related motorcycle dealership industry is expected to reach $34.4B in annual sales in the United States for 2022. The industry is expected to reach $131B globally by 2028, according to Insight Partners, which forecasts annual growth of just under 5% for the next six and half years.Similarities to Auto DealersDealer Agreements – Like traditional auto dealers, powersports dealers have formal agreements with the manufacturer of the vehicles. In powersports, they are referred to as dealer agreements rather than franchise agreements but consist of many of the same elements including territory/area of responsibility, exclusivity of competition, sales volume requirements, etc. One key difference in these arrangements is that most powersports dealers will have dealer agreements with multiple OEMs whereas a higher percentage of auto dealers have only one franchise agreement (single point stores). While all the headlines seem to be about larger public or private auto dealership groups with multiple rooftops in one legal entity, 93% of owners had 1-5 auto dealerships in 2021. By contrast, a powersports dealer may have dealer agreements with Kawasaki, Yamaha, Polaris, Suzuki, Sea Doo, etc.Departments/Profit Centers – Most powersports dealers have four departments or profit centers: new vehicle, used vehicle, service/parts, and finance/insurance. While most powersports dealers do not have rigid/formal financial statements that have to be submitted monthly to the manufactures like their automotive counterparts, there is useful information in their financials to analyze the size and overall profitability and performance of each department. Generally, there is less unit/volume information provided in the financial statements than auto dealers whose manufacturers use this data in order to determine which models are selling better than others.Industry Terminology – The value of a powersports dealership is typically reflected in a single dollar value and as a reflection of Blue Sky or the intangible value of the various brands/dealers they represent. As with auto dealers, the Blue Sky value can be expressed as a multiple of normalized pre-tax earnings. One distinct difference in powersports is the lack of published blue sky multiples. The lack of published multiples makes the valuations, and specifically the market approach, more difficult for powersports dealers. Dealers in this industry subsection also pre-purchase inventory from the manufacturer and refer to the related liabilities as floor-plan debt like their auto dealer counterparts.Recent Industry Conditions – Inventories have also been constrained like traditional automobiles due to ongoing supply chain issues of raw materials and microchips, and also intermittent plant shutdowns of the manufacturers. With tight inventories coupling with high demand, profitability for powersports dealers has also increased in the last two years, but to a lesser degree than the profitability of auto dealers.Pre-order/Direct to Consumer Sales Model – Powersports dealers have shifted more towards pre-orders and several manufacturers have introduced more direct sales models to consumers. Our understanding of this trend in powersports is more directly related to the constraint on new vehicle supply than the struggle over profit allocation between the manufacturer and the dealer occurring in automobiles. Nevertheless, the manufacturer and the dealer are both vying for the ownership of the customer and their related purchasing experience. In our view, direct sales may make more sense for powersports dealers who more frequently see customers wanting customized features on their rides.Zero Emission/Electric Vehicles – The powersports industry is not immune to the increase in investment and the proliferation of electric vehicles that are also occurring with traditional automobiles. Powersports manufacturers emphasize combining electric power trains and battery systems in their vehicles. For example, Polaris introduced a new electric Utility Terrain Vehicle (UTV) Ranger EV equipped with a single 48-volt induction motor with 30 horsepower.20 Group or Peer Groups – Several of our powersport dealer clients belong to peer groups. While not as formal and frequent as their auto counterparts, peer groups can benefit powersports dealers. These groups provide forums for best practices and opportunities to improve the overall management process of the dealership. Further, peer groups can provide comparable sales and profitability data with other dealers in your region that can provide evaluation and benchmarking activities. Powersports dealerships used to be primarily run by enthusiasts who got into the business because they simply enjoyed their vehicles. Over time, management has become more professional particularly as more auto dealers have entered the space, which partly explains why powersports operations have come to more closely resemble auto dealers over time.Differences From Auto DealersMore Dependent on Macroeconomic Factors - Since most of the purchases in the powersports industry represent secondary/alternative or recreational vehicles, this industry is more dependent on macroeconomic factors than the auto industry. As auto dealers have seen in the past year, demand for primary personal vehicles may be more inelastic than previously thought. Specific factors such as the level of disposable income and customer sentiment are important in the powersports industry. Households with median incomes over $100,000 tend to purchase more vehicles in the powersports segment. Consumer sentiment measures the level of optimism consumers feel about their finances and the state of the economy. Consumer sentiment indexes also predict how likely consumers are to buy things based on changes in economic activity. The pandemic had conflicting impacts on the powersports industry. On one hand, business shutdowns and unemployment had a negative impact on the industry. Conversely, the shift to more outdoor recreational activities had a positive impact on the industry. It will be interesting to see how the current economic conditions will impact the industry for the remainder of 2022.More Dependent on Demographics/Geographic Location – While these factors are important for auto dealers, they are perhaps more important for powersports dealers. We have previously written about geographic markets favoring certain brands or types of vehicles, such as trucks in Texas, or SUVs and crossovers in Colorado or Alaska. According to IBIS World, nearly 44% of consumers buying motorcycles and powersports vehicles are between the ages of 25 and 49. Further, since most of these vehicles are used for recreational or secondary purposes, the location of a powersports dealer and the balance of its proximity to rural and urban areas can be critical to performance and success.Less Competition – The number of auto dealerships in the United States has ranged between 16,000 and 17,000 for the last several years, despite the consolidation and transaction volume. While not as clearly defined, First Research reports approximately 7,000 motorcycle dealers. First Research, like IBIS World, are industry research publications that define the industry as including motorcycles, sport vehicles, ATVs, scooters, etc. Whatever the exact comparable number of powersports dealers in the United States, there is much less competition than traditional auto dealerships. Auto dealers compete with countless local/regional dealers in the various franchise segments (domestic, import, mass market, luxury, etc.). Powersports dealers typically compete with 1 to 4 similar dealerships depending on their geographic location. With fewer powersports OEMs and the greater likelihood that a dealer carries these brands themselves, competition on the local level can be a lot easier for dealers that also compete in the auto industry.Repairs & Maintenance as a Percentage of Original Cost – The amount of customization on recreational vehicles is typically a higher percentage of the original cost than for automobiles. Further, powersports vehicles also require more frequent repairs and maintenance than automobiles. Recreational vehicles are subjected to extreme terrain and conditions, such as mud, water, and off-road terrain, causing components to require more repairs or seasonal maintenance. Like auto dealers, these types of services tend to be higher margin and more frequent, which are advantageous from a valuation perspective.ConclusionsThe powersports industry is growing in terms of size and popularity. Numerous similarities to auto dealers could lead to common ownership or potential growth opportunities. Contact a professional within the Auto Team at Mercer Capital if you have a powersports dealership or are evaluating an investment in a powersports dealership.At Mercer Capital, we follow the auto industry and adjacent industries closely 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 and litigation support engagements.

Q2 2022 Public Auto Dealer Earnings Calls

Persistent New Vehicle Inventory Shortages Keep Days’ Supply Low and Pre-sales High - Consumers May Be on Shakier Ground, But Demand is Still Strong

Earnings Calls: Executive SummarySupply 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."I think the new car business is solid, but it's really hard to understand how strong it is because you have such a low days supply. Generally speaking, we're still pre-selling half the cars that are coming in. So a lot of these cars aren't getting to hit the ground. It varies a little bit by brand, but generally, that's where it is overall." – David Hult, CEO, Asbury Automotive GroupWhen you look at our domestic business, about half of our pipeline is pre-sold. When you look at our volume imports, it's 80%, some as high as 95%. And when you look at our luxuries, it's in the 60% range. And that is right where it's been for the last couple of quarters." – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive"I would say on new vehicles, about one-third of our product is pre-sold that's coming in. So that's good. And I think it's a lot of high-demand vehicles. The rest of the stuff may be wait-listed, but it's not pre-sold where we have money on the car. […] We don't have the exact data. We got it by franchise somewhere. But I would say it was close to 50% 90 days ago. So since interest rates have come up, it's definitely affected things, but it's still a robust environment where those cars hit the ground. And if someone that wants to drive the car and there's two other people waiting to drive the same car, and it's still a bit of a frenzy." – Bryan DeBoer, President and CEO, Lithia Motors"Demand is strong as we mentioned. Inventory levels are still incredibly low, high turn rates, and really sustained margins over the last few quarters. In the first quarter, from memory, I reported something like 50% of our incoming three months inventory was sold. I would say that on the domestic side, that is now down to about 35%. On imports, it is sustained, and on premium, it is also largely sustained." – Michael Manley, CEO, AutoNationTheme 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."Similar to the last few quarters, we continue to see limited new vehicle production and inventory levels due to supply chain disruptions and strong consumer demand for new vehicles. This contributed to a 33% decrease in same-store retail new vehicle unit sales volume higher than the industry retail SAAR decline of 20% due to our luxury and import weighted brand mix, which continues to have lower days' supply of inventory than domestic brands"– David Smith, CEO, Sonic Automotive"Our domestic days' supply on new is around 60 days. So we have pretty good flow even though there's some in-transit on that. Really our softness in days' supply, which is where we really are selling every car that we get about as quick as we can get them is in our imports, which we're sitting at a 16-day supply and our luxuries are sitting at about a 29-day supply."– Bryan DeBoer, President and CEO, Lithia Motors"We have a 21-day supply of new vehicles with premium at 23, volume foreign at 8, and domestic at 21. New vehicle supply is at 12 days in the U.S. and 32 days in the U.K. We continue to sell into our future new vehicle pipeline to support tour customers, maximize inventory turn and minimize our inventory costs."– Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 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."With consumers financially healthy, consumer financing readily available, the car park aged to record levels and sizable pent up demand combined with our technology to improve efficiency and productivity, we are well-positioned to weather the current market conditions. […] I would say people were impulsively buying six months ago. They're probably putting a little bit more thought and care into the selection and the pricing right now."– David Hult, CEO, Asbury Automotive Group"We're seeing no tightening whatsoever. When you think about the asset class performed very well in 2008 and '09. And when I talked to the head of these finance companies, as I said, they're seeing some delinquency increase on the lower end but its back to pre-COVID levels. But I think the reassuring part of that is losses are historic lows and the appetite for car loans is robust. So, we have not lost any car business because of the availability of credit."– Peter DeLongchamps, SVP, Manufacturer Relations, Financial Services and Public Affairs, Group 1 AutomotiveThe demand is there, but the demand is not there for a $640 monthly payment for preowned that's what you're getting and you're selling a 1- to 4- year car right now at $30,000 to $31,000. And so retooling to the 5-year-old plus cars, we're able to get that monthly payment back down into the $400 range, which is historically where it needs to be. So, consumers are buying a little higher amount car at a lower payment. And we've been able to continue to keep our warranty penetration up there. So not concerned at all about preowned demand."– Jeff Dyke, President, Sonic Automotive"Today with delinquencies going up on retail across all other markets, I wonder -- and then you're going to blow up your balance sheet. And on top of that you're going to have to take that and sell it into the market and securitize it. And I think today, the people that buy that are going to say is this really what we want to buy 72-month or 60-month paper from the standpoint in the car business with the inflation that we've had on used car prices? So not that we won't ever get into it, but we think it's a bad idea. Right now, we don't think that glove fits our hand."– Roger Penske, Chairman & CEO, Penske Automotive GroupConclusionAt 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.

July 2022 SAAR

CHIPS-Plus Act Passes: What Does That Mean for Auto Dealers?

The July 2022 SAAR was 13.3 million units, an improvement from last month's 13.0 million units but down 10.2% from July 2021's rate of 14.7 million units. The SAAR continues to reflect depressed sales rates as supply chain shortages restrict volumes across the United States. The first half of 2022's average SAAR was 13.8 million units, and the beginning of the third quarter has already come in below that figure, further dragging down the full-year 2022 average SAAR. It seems unlikely that the full year SAAR will manage to reach 15 million units absent an unforeseen dramatic reversal.In last week's blog post, the Mercer Capital Auto team discussed industry-wide and Mercer-specific 2022 predictions and laid out revised expectations for the remainder of 2022. In the interest of our regular subscribers, we will not lay those points out for two weeks in a row. See below for some of our regular SAAR blog charts comparing sales and inventory metrics over the last several years:"CHIPS-Plus" Passes – What Does That Mean For Auto Dealers?Several of our posts over the last year have covered the persistent semiconductor shortage in automotive manufacturing. This particular shortage, among other parts' shortages, has been a significant drag on production for over a year now. As far as forward expectations go, most folks that follow the industry have assumed that it would take multiple years for domestic chip-making operations to be able to handle the volume needed to make a dent in chip pricing and availability over the long term. This assumption seems reasonable to us, and not much has happened over the past six months that could change that narrative until this past week.The House of Representatives and the Senate just passed a $280 billion "CHIPS-Plus" (Creating Helpful Incentives to Produce Semiconductors for America) bill in a bi-partisan vote on July 28th, sending the measure to President Biden's desk to be signed into law on August 3rd. This bill raises several questions throughout the auto industry: How will this bill affect the consensus timeline for domestic chip-making facilities to come online? Will the bill subsidize chip-making in a way that will take pressure off pricing? Is there an auto-specific clause in the bill, and if so, what does it lay out? In this post, we try to answer some of these questions and lay out the bill's general structure and contents.Key FactsA recent Forbes article highlights some key facts related to the CHIPS-Plus bill:The bill passed 243 to 187, with 24 Republicans voting alongside 219 House Democrats, one day after the Senate passed it in a similarly bi-partisan 64-33 vote.The bill highlights $52.7 billion in subsidies for U.S. computer chip manufacturing, $39 billion in assistance to build semiconductor facilities, $11 billion to support Research and Development, $2 billion for defense-related chip manufacturing, and $1.5 billion for public wireless supply chain innovation.The bill creates a 25% tax credit for semiconductor manufacturing. The bill also appropriates $10 billion for the Department of Commerce to create 20 regional technology hubs. Political supporters of the bill have touted the measure as a way of easing the microchip shortage by helping the United States catch up with East Asia, which currently produces 75% of the world's microchips. Many of these supporters have said that the bill is critical to national security and the United States' economy, especially given the fact that its key economic rival, China, has rapidly increased its market share in recent years. Wall Street is likely to welcome the support as well. According to a recent Bloomberg article, the Philadelphia Stock Exchange Semiconductor Index has fallen 30% over the past year leading up to the bill's passing, marking the index's worst annual performance since 2008. All 30 stocks in the index were down for 2022 prior to the bill's passing. This decline in semiconductor companies' stock prices can be attributed to rising interest rates and is a part of a larger trend in the equities market (the year-to-date S&P 500's performance was -12.11% as of the writing of this blog). It is great for business owners when the capital markets and the United States legislative bodies come to an agreement on any one thing, so this seems like a win for everyone involved, especially auto dealers and manufacturers. See below for some commentary on how this bill is expected to affect the auto industry.How Does CHIPS-Plus Affect Auto Dealers?While this bill is designed to support domestic chip-making for a large swathe of industries, it is clear that auto manufacturers' pain is among the most severe. According to a recent Automotive News Article, The American Automotive Policy Council released a statement in late July, saying that "There is not a single supply-chain shortage with a greater impact on the U.S. economy than the shortage of automotive-grade semiconductors."Lobbyists and spokespeople for the industry have echoed this sentiment, making it very clear that automotive companies are looking for support to come sooner rather than later, as the process of building a semiconductor fabrication plant can take anywhere from 2-3 years and many of the United States' prospective facilities have been underway for some time now. Senator Gary Peters, a representative from Michigan, has been very outspoken in his support for the CHIPS-Plus bill, saying that "This problem only gets bigger as time goes on. […] The demand for chips is increasing every single year, dramatically. We have to get in front of this problem. […] We have to start building these facilities now."This legislative development is clearly a big win for the auto industry. But how so? What specific positive impact might this bill have? Below, we try and answer some of the questions raised earlier in this blog:So does CHIPS-Plus mean that facilities will come online sooner? The short answer is that it is unlikely. While this legislation might help subsidize these facilities and encourage more facility construction to begin, more subsidies cannot speed up the construction process in a meaningful way. The target for many of the domestic chip-making facilities to come online is still mid-2023. The subsidy is more likely to increase the number of facilities rather than the rate at which they appear.Will the bill subsidize chip-making in a way that will take pressure off pricing? Perhaps. In general, government subsidies are designed to either 1.) encourage an economic activity that might otherwise not occur or 2.) take pressure off of the consumer by artificially lowering the costs of the producer. In the first scenario, legislators might believe that the total economy-wide benefits of chip-making will create positive externalities, or side effects, in the economy, making the subsidy worth taxpayers' money. In the second scenario, producers receive subsidies and can lower prices due to costs being artificially lower, encouraging the purchase of chips through bargain pricing. In our opinion, the first scenario makes more sense in this case, as the demand for microchips is already very healthy. Hopefully, the externalities that come from this bill will carry positive side effects with it, especially for auto dealers.Is there an auto-specific clause in the bill, and if so, what does it lay out? Yes and No. There is not an auto section of this bill, but the auto industry is mentioned two times in the text of the actual bill:Auto manufacturing is mentioned in Section 102 of the bill, referring to the $2 billion incentive program aimed at legacy chip production facilities. This money is intended to support existing facilities in "key industries" as they try and meet demand in the meantime while new facilities come online.Auto manufacturing is also mentioned in Section 103 of the bill, clarifying and amending 2021 legislation to fall in line with Section 102 mentioned above. These sections are aimed at a short-term fix to a long-term issue, with the long-term fix being the new facilities mentioned throughout this blog and throughout the legislation. Going forward, hopefully, this government funding can create some breathing room for manufacturers and dealers in the short term while also addressing the long-term solution.August 2022 OutlookMercer Capital's outlook for the August 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps August's SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

2022: How Is the Auto Industry Doing and What Does the Future Hold?

Status Quo or Winds of Change?

The first half of 2022 is behind us, and with school about to start, report cards will be here before we know it. In that same light, the auto industry has published its statistics for the first six months. This post reviews predictions by industry analysts (and us) made at the beginning of the year by analyzing several key metrics. Additionally, we discuss threats that arose during the first half of 2022 and their impact on the auto industry for the remainder of the year and perhaps longer. Finally, we offer a few predictions for the second half of 2022.Review of 2022 PredictionsMost analysts predicted vehicle sales would continue to improve in 2022 due to pent-up demand from vehicle deficits caused by production shortfalls in the last two years. While demand would continue to outpace supply, analysts believed the tight supply of new vehicles would gradually improve in 2022. Finally, analysts predicted that the production of microchips would begin to see some improvement this year.In terms of predicting the annual SAAR, or estimate of new vehicle sales in 2022, most early estimates ranged between 15-16 million units.Recall the original causes of the microchip shortage stemmed from the following events: 1) OEMs canceled orders of microchips in the early days of COVID-19 as the production of new vehicles waned in the aftermath of shutdown orders for OEM plants and dealerships alike; 2) there was a huge increase in the demand of consumer electronics; and 3) supply chain disruption from the production and plant shutdowns of the microchip factories themselves.Mercer Capital’s predicted a similar bounce back in the production of new vehicles stemming from the vehicle deficit of the last two years. We also predicted there would be fewer incentives offered by the manufacturers, fewer models available, and fewer features on vehicles.We revisit how industry analysts and Mercer Capital fared in these predictions later in this blog.New Threats in 2022Through the first six months of the year, new threats to the auto industry and the general economy have emerged. Headlines have been dominated by inflation (at the highest levels in 40 years), rising interest rates, and rising gas prices. The auto industry is impacted directly or indirectly because these economic headwinds affect a consumer's ability to purchase and finance a new or used vehicle as well as the total vehicle miles traveled.Also contributing to these threats is the Russian invasion of Ukraine and its impact on the production shortage of microchips. Raw materials, such as neon gas that have been compromised during this war, are a key component in the manufacturing of microchips. Additionally, the war has caused production plant shutdowns and further supply chain disruptions for OEM and microchip plants located in/or adjacent to the area.OEMs and the United States are trying to mitigate the impact of the microchip crisis and our dependence on importing these components by opening microchip production facilities domestically, but these will take some time to develop and begin production. Analysts, ourselves included, may have been too optimistic as to how quickly this industry could scale supply to meet increasing demand. (Stay tuned for a microchip update in next week’s SAAR blog).If the current market conditions of inflation, rising interest rates, and rising gas prices lead to a recession, there could be further impacts on the overall auto industry. Yet, depending on your definition, we may already be in a recession. U.S. auto sales declined by 40% during the Great Recession and fell nearly 15% for the first two months of COVID-19, compared to those same two months in 2019.New Vehicle ProfitabilityWith high demand, tight supply, and less incentives offered by the manufacturer, it’s not a surprise that the average transaction prices of new vehicles have been at record levels in 2022. One interesting trend has been the increased shift towards crossovers and light trucks compared to smaller cars which are more fuel efficient. It remains to be seen whether rising gas prices will swing this pendulum back.In addition to high vehicle prices, the total retailer profit per unit realized by auto dealers has also reached record levels. According to the monthly forecasts from JD Power and LMC Automotive, profitability from this metric have been between $4,900 and $5,300 per unit since December 2021. As a point of comparison, this same metric totaled only $2,053 per unit in December 2020, as seen in the graphic below: While the monthly totals in the first and second quarters of 2022 have fluctuated slightly, there doesn’t seem to be any indications yet of this trend changing.Supply of New VehiclesEvidence of the tight supply of new vehicles in the last few years can also be seen in the lack of inventory on auto dealer lots across the country. It’s not uncommon to see more empty spots on the lot than spots filled with new inventory.Another similar measurement of the lack of inventory is the average time in days that a new vehicle sits on the lot before it is purchased. The monthly forecasts provided by JD Power and LMC Automotive report these figures between 19 and 20 days for each month in 2022, a slight uptick in the December 2021 figure of 17 days. As a point of comparison, this metric totaled 72 and 71 days for December 2018 and December 2019, respectively, as seen in the graphic below: In our discussion with auto dealer clients, they continue to indicate that they are operating on a selling volume of 50-75% of pre-COVID years, but at 2-3X greater gross profit – a further reflection of these first two metrics. Dealers and industry analysts both predict the OEMs will increase the supply of new vehicles above current levels when they are able to try and reclaim some of their lost profitability on these units.Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.While most analysts and dealers do not predict the average day's supply will reach pre-COVID levels, there is certainly room between current and prior-year levels. Based on this statistic and overall industry conditions, any improvement in supply seems to be minimal and gradual through the first half of the year. Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.Average Age of CarsS&P Mobility recently released its annual study on the average age of cars on the road in the U.S. As the graphic below indicates, the overall combined average is 12.2 years: This figure shows a slight increase over last year’s study, which concluded the average age to 12.1 years. In fact, this combined figure has grown every year for over a decade. These figures show no signs of decline and could be easily predicted to continue to rise, especially if a recession hits. At some point, conventional wisdom says the average age of cars will peak and begin to decline as consumers have to trade in for a more recent model. However, improvements from OEMs may structurally improve vehicle life cycles just as many hot new features have quickly become standard. The average age of cars also highlights the continued opportunity for auto dealers in terms of fixed operations (service department and parts). Aging cars will require more service than newer vehicles. This opportunity could be mitigated somewhat during a recession, as consumers could be apt to drive fewer miles due to rising costs or lack of employment. In fact, another statistic affected by a recession is total vehicle miles driven. This figure declined sharply for the two years during the Great Recession and also declined rapidly from the effects of COVID-19. The rolling twelve-month average for total vehicle miles driven has finally climbed back to near pre-pandemic levels as of May 2022 (most recently published data). A market recession could easily reverse that trend for the remainder of the year and the length of the recession.Average Trade-In Equity Value of Used CarsLike new vehicles, used vehicle transaction prices also reached record highs in 2022. While the supply of used vehicles has improved gradually, like its new vehicle counterparts, it has not returned to pre-COVID levels. Since fewer new units are available for sale, fewer used vehicles are traded to the dealer. However, the average trade-in equity value for used cars has followed the same trends as profitability on new and used vehicles. According to the monthly forecasts from JD Power and LMC Automotive, the average trade-in equity value has ranged between $9,300 and $10,400 since December 2021, compared to $5,626 just one year prior in December 2020: Rising trade-in values and, perhaps more importantly, equity are key components of rising vehicle prices. Through the first six months of 2022, there is no sign of trade-in values cooling, although those could be impacted in the coming months by the emerging new threats or the onset of a recession. Consumers tend to be more focused on their monthly payment, so a $5,000 increase on vehicles purchased and traded in are a wash to the consumer. If this metric begins to stumble, we expect it to impact transaction prices similarly.Fleet SalesFinally, we examine fleet sales in recent months. In more robust times of new vehicle production, dealers are able to sell off excess inventory in high volumes to rental car companies, government agencies, and corporations, albeit at much lower margins. Fleet sales were also greatly impacted by COVID-19 as rental car companies sold off large portions of their fleet to conserve cash as consumers were no longer traveling during stay-at-home orders.Fast forward two years, rental car companies and others have not been able to replenish their fleets as the entire industry has been operating at a new vehicle deficit. Anyone that has tried to rent a car in the last few years has experienced the lack of availability and heightened prices. We have a friend who recently rented a U-Haul truck on a vacation because the price was half of a rental car. While these conditions have improved recently, fleet sales and corporate fleet sizes still represent a distressed industry segment.As reported by JD Power and LMC Automotive, monthly fleet sales have rebounded some in 2022, but their monthly unit sales are still down almost 50% from prior levels depending on the month, as seen in the graphic below: Another view of fleet volumes can be measured by the percentage of sales of fleet vehicles vs. the overall sales of all new vehicles. According to Cox Automotive, fleet sales have comprised approximately 13-14% of overall new vehicle sales for 2020, 2021, and year-to-date 2022, compared to nearly 19% in 2019. It should also be noted that those reduced percentages representing fleet share are also on greatly reduced overall new unit sales from the same time periods.ConclusionsSo how did industry analysts and Mercer Capital do on their beginning of the year predictions, and where are we headed? Jonathan Smoke from Cox Automotive originally predicted 2022 SAAR at 16 million units. He lowered that prediction to 14.4 million units in the last two months. The predicted trends of high demand, tight supply, and increased profitability have all held through the first six months, although there are signs of softening in new vehicle sales with continued production shortages and rising interest rates. While optimism remains, we’re simply running out of time in 2022 to revert to higher levels, so we expect these predictions to continue to be revised towards where performance has been.How did Mercer Capital do with some of our predictions? While we were correct on fewer incentives from the manufacturer and fewer models available with fewer features offered on those vehicles, we were incorrect in predicting a higher SAAR in 2022.While some of these metrics remained strong, the emerging threats and the onset of a recession could trigger a reversal of fortune for the auto industry and the profitability of auto dealers sooner than most would have predicted at the start of the year.At Mercer Capital, we follow the auto industry closely 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 and litigation support 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.

Carvana Is Looking More Like Icarus

How the Pandemic Darling May Have Flown Too Close to the Sun

Lately, Carvana has been in the news for all the wrong reasons.Its share price is down over 90% since its pandemic peak and currently sits below the low levels of March 2020.This post provides an abbreviated history of Carvana from its founding in 2012 to 2022 and discusses what its successes and struggles mean for traditional auto dealerships.Where It All beganThe company was founded by Ernie Garcia III in 2012. Garcia sought to improve the vehicle buying experience for consumers. He attributed the idea partly to how cars are bought and sold at wholesale auctions. These auctions are key sources of supply for auto dealers, particularly used vehicle dealers with limited opportunities to acquire cars via trade-ins. Garcia noted it took dealers all of 30 seconds of seeing a vehicle to purchase it. His vision was to bring this ease of acquisition mainstream.Prior to founding Carvana, Garcia began working at DriveTime Automotive Group in 2007, an auto giant owned by his father. This is where he got the idea of selling cars online, though it would take years for this idea to take off.What Makes Carvana UniqueCarvana has become known for its iconic car vending machines which debuted in late 2015. These worked as a centralized location for customers to pick up vehicles, lowering delivery costs. It was also a novel concept with marketing benefits for the brand. Compared to a traditional dealership, going vertical reduced the upfront investment in real estate compared to large, expansive lots that are largely sitting empty in the current inventory shortage.Another thing that makes Carvana stand out is its online-first presence. Carvana operates as an online platform to buy and sell used cars, but this option for consumers isn't new. The difference with Carvana is that the company acts as the dealership rather than taking a fee for simply listing the vehicles. The company also earns a substantial amount of its gross profit from financing rather than the actual sale of vehicles. Vehicle financing has increasingly become a key aspect of profitability for traditional dealerships as well.While Carvana fixes the vehicles it purchases prior to reselling them, they don't provide after-sale services like repair and maintenance, a key driver of profitability for traditional dealerships.Scaling the BusinessCarvana seeks to provide a uniform buying experience with price transparency, an oft-cited pain point with traditional auto sales for consumers. To achieve this, the company needed to significantly increase scale in order to be profitable.A few years after its founding, the company struggled to gain traction. It resorted to two tactics instrumental to the company's success. First, it subsidized consumers by selling vehicles at or sometimes below cost. This, of course, raised the company's sales from a volume perspective and contributed to significant growth. The company has for years sold a growth story like many other online companies. The thought process is that it can increase its prices once it achieves sufficient scale using its aggressive pricing strategy.Carvana's strategy was to use its aggressive pricing (selling cars at or below cost) to create scale. From there they could increase prices and reach profitability.Carvana's second tactic was listing its inventory in numerous markets. While it had fewer cars to sell than its competitors, it began using virtual addresses in order to appear to have a presence in more markets than it actually did. Consumers surveying their options might go into a dealership if they know the brand they want but aren't sure about the model. Before Carvana, third-party listing sites were a better way to start the research process for consumers that were brand-agnostic.Carvana's strategy enabled its vehicles to show up in more markets, and they subsidized the cost of shipping the vehicle once a sale was recorded. While this strategy was not sustainable from a profit perspective, the investment paid off and generated significant traction. The company's IPO in 2017 further increased its visibility, and its growth story and positioning as a "disruptor" captured public attention in an industry with room for improvement in the customer experience.Flying Too Close to the SunThe company rode its growth story to a stock price of $110 in February 2020. In less than a month, concerns around the COVID-19 pandemic led the stock price to decline 73% to $29. Less than a week later, the stock was back to $63 as the market, at large, sought to reprice all stocks based on uncertain expectations of the path forward.By June 2020, the stock peaked again as the company was viewed as an early "winner" from the pandemic. Auto sales plummeted in March and April 2020 as dealers were thrust into the world of online sales as a means of survival. For Carvana, the forced shift to online played directly to their strengths.Prior to the pandemic, the online market for purchasing vehicles was presumed to be relatively small. While online retail works great for certain products, large purchases like cars and mattresses were supposed to be impervious to the "Amazon-ification" of retail. There were two main reasons for this thesis: life cycle of the purchase and cost.It has long been held that consumers spending large sums of money on products they intend to use for years want to touch and feel what they're buying to ensure they like it. The last thing you want to do is get a bad night's sleep on a bed the first night after you've just shelled out $100s of dollars for a new mattress. The same can be said for the style and feel of automobiles, which is why dealers keep so much inventory on the lots for consumers to test drive various options.Consumer financing for cars can also be difficult to complete online. Having a dealer walk people through their options or direct them to more affordable options is beneficial to the dealer who still gets the sale and the consumer that needs help wading through the financing process. Carvana appeared to solve both of these problems with easy-to-use online financing tools and a 7-day test drive period. This was a plus compared to the traditional ~30 minutes a consumer spends with a vehicle prior to purchasing it from a dealership.Before the end of 2020, it was clear that auto dealers (both traditional and online) were benefiting from the economic environment caused by the pandemic as sales bounced back and an increased reliance on technology and lower headcount, interest rates, and advertising led to lower costs. As the pandemic continued, auto dealerships saw heightened profitability, and Carvana's stock price soared to a high of $370 in August 2021. Conditions were so strong that the growth-focused Carvana actually reported positive earnings per share in Q2 2021. This appeared as though it could be the turning point for the company. Maybe it was reaching the necessary scale to generate large profits in the future.Unfortunately, the wind has been taken out of its sales as the macro environment has changed in 2022 with rising interest rates and now fears of a recession. At $25 as of last Friday (July 22, 2022), the stock now sits lower than it did in the depths of the pandemic and is closer to where it traded in the first half of 2018. It's fair to raise the question: "If the company couldn't make money in the most ideal of conditions for auto dealers (in addition to forced adoption of online retail), what is its ultimate path to sustained profitability?" While the company's innovative ideas generated plenty of traction with consumers, they did not lead to a moat for its operations. Stated plainly, other companies can copy Carvana's offerings, reducing or removing all of its competitive advantages from being the first-mover.Recent StrugglesMatching stock price declines, headlines about Carvana are becoming increasingly negative as its fairy tale ride may be coming to an end. Recently, the company has announced layoffs in order to preserve cash. However, a smaller staff may only exacerbate the back-end paperwork issues the company is currently facing. While the company downplays the pervasiveness of the issue, an article in Barron's (subscription may be required) chronicles consumers' struggles with registration delays and issuance of multiple temporary license plates from various states enabling it to sell vehicles for which it had not yet received the title. In many states in which the company does business, such sales are illegal. For these consumers, the relative ease of front-end purchase as compared to in-store dealerships may not be worth the back-end headaches as Carvana seeks to straighten out these issues. Long-term, Carvana is selling a better customer experience, which will extend beyond the initial purchase by getting all the necessary paperwork completed to be street legal.Anecdotally, we had a colleague last week who spent the better part of a day at the DMV attempting to get his car registered after temporary plates could no longer be extended by law. While the DMV may have shared in some of the blame in this situation, he has yet to receive a title four months after purchase. Interestingly, there were about ten other people at the DMV with similar Carvana issues, though many of them were happy, loyal customers that raved about the front-end experience despite the back-end frustrations.Carvana's core profitability lever (financing) is seeing demand cool.In addition to back-end issues, the company's core profitability lever (financing) is seeing demand cool. While Carvana is well-known for its vending machines and no-haggle pricing on its website, its earnings (or lack thereof) are more dependent on its financing. Instead of marking up the vehicles, it sells to market levels, the company subsidizes lower purchase prices to scale and also makes money on the auto loans it originates. Rather than holding these on its balance sheet, the company packages or "securitizes" these loans and sells them to investors.With near-zero interest rates and a strong economic environment, there was plenty of demand for the increased yield offered on these loans. However, with concerns about the financial strength of consumers and rising interest rates, there is less demand for the loans generated by Carvana. In the second quarter, Carvana didn't sell a pool of non-prime loans. In previous quarters, it had securitized both prime and non-prime loans. The company is due to report "earnings" on August 4, and some analysts are pessimistic.Takeaways for Auto DealersDespite its issues, Carvana is the poster child for many consumer-centric shifts in the car buying space.Consumers across the country now have numerous options to buy vehicles online, with extended test drive options becoming more available. Carvana's decentralized approach and lower investment in real estate may also change the level of investment needed for the dealership of the future, though one could argue the current inventory shortage situation may have pushed the industry in this direction even without Carvana.The auto dealer industry will continue to rely on and require investments in technology, particularly technology centered around the online buying experience. Dealers unwilling or unable to make these investments may opt to divest their dealership while profits and values are at relative peaks.The fortunate thing for dealers is their access to new and used vehicles, in addition to financing and servicing of vehicles, ultimately means there are numerous potential profit centers that provide downside protection through all economic cycles. Online retailers like Carvana are seeking to disrupt the industry, but their lack of new vehicles and service departments put them at a distinct disadvantage that even explosive growth may not be able to overcome.Mercer Capital follows the key players in the auto industry in order to stay current with the operating environment of our privately held auto dealer clients. To see how these trends may impact your dealership, contact a Mercer Capital professional today.

Meet The Team

David W. R. Harkins, CFA, ABV

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight David Harkins, Senior Financial Analyst.David Harkins, CFA, ABV began his valuation career at Mercer Capital as an intern in the summer of 2016. After finishing his degree at Sewanee in 2017, David joined Mercer Capital as a financial analyst in the Memphis office. In 2018, he drove a U-Haul up I-40 to Mercer Capital’s Nashville office and began covering auto dealerships. Since then, he has worked on various types of engagements for auto dealerships including marital dissolution, gift/estate tax planning, shareholder oppression, and limited procedures buy and sell side analysis, among others.What is your favorite part about working with auto dealerships?David Harkins: I like all the analytical detail provided on the monthly factory statements. There is a certain uniformity, even across the various brands, that makes it easier to analyze the dealership and compare dealerships across brands. I know right where to go for the key value drivers, such as the volumetric information and data by department. We started our Auto Dealer blog during the depths of the pandemic, so that timing wasn’t necessarily great. But the discipline of weekly content has been extremely helpful to my understanding of the industry. That is particularly the case when it feels like industry news, trends, and disruptions are occurring on a weekly basis. I enjoy following the industry because of its benefits when discussing expectations for dealerships with our clients. We can speak their language better than a business valuation generalist that may not do another auto dealership that year. We have the greater context of the industry at large, so we can spend more time on the key impacts they see for their brand(s) in their market(s).How does your CFA background assist with analyzing auto dealerships?David Harkins: I think the CFA designation has three primary benefits. The first and most important in my mind is the analytical rigor of the tests and the knowledge gained from committing to passing each level. I did not take many accounting classes at Sewanee, for instance, and it deepened my knowledge of the interaction between the three main financial statements. Additionally, the CFA impressed upon me the importance of valuing the expected cash flows in order to determine the value of any business interest. For auto dealers, cash flows have improved since about mid-2020, and it seems increasingly likely that at least part of this benefit will be retained once the supply chain disruptions moderate. The question for valuation analysts is at what level will earnings settle? The market largely sets the multiple for businesses where high-growth industries (e.g. big tech) are likely to receive higher multiples than declining industries (e.g., big box department stores). If the market sets the multiple, the analyst's job is to understand the expected level of ongoing earnings, which is then capitalized by the multiple. The corollary benefits of the designation are networking opportunities and a recognition that I have a strong analytical background. I believe these will both help me as I develop in my career, but I have yet to be able to use them fully. I received the charter in August 2020, so opportunities to meet more folks have been somewhat limited, though it’s been great to attend events such as TAA and NADC. Hopefully, the CFA will provide a nice complement to these activities.What is a unique challenge when working with auto dealerships?David Harkins: I think parsing the allocation of value by rooftop is interesting. Haig Partners and Kerrigan Advisors publish Blue Sky multiples in a quarterly newsletter that is brand specific (because the market tends to ascribe higher multiples to luxury dealerships, for example). This analysis quickly becomes complicated for auto groups carrying more than one brand. Having multiple rooftops is a great expansion strategy for dealers that provides cross-selling opportunities and risk mitigation if one brand has a lackluster product lineup. It can also expose the auto group to various points along the demand curve where luxury might outperform in a strong market, whereas more economical offerings might do better in periods of market turbulence. If a company has a Lexus and a Toyota dealership whose mid-point market multiples might be 9x and 7x, respectively, what multiple gets applied to a transaction involving both dealerships? Part of the reason dealer principals want to add rooftops is what makes this analysis more difficult: sharing of operating expenses. If a dealer principal is paid $100,000, how much of that salary is attributed to one dealership or another? Without truly separate P&L statements, it takes more art than science to determine the contribution to value of multiple rooftops.What did your internship at Vulcan Materials Company teach you that has translated to your work with auto dealerships?David Harkins: Prior to my internship at Mercer Capital, I got the chance to intern at Vulcan Materials. While I was an intern at Vulcan, I think I gleaned a fair amount about how a public company operates. I worked primarily with the market research department and was impressed by the internal/proprietary research available to the company. Given the large size and intentional growth exhibited by the six public auto dealership companies, I’m sure they have similar departments, which afford them numerous insights into where the competition is and where it’s going. While industry resources are available to analysts at valuation shops like Mercer Capital, it will likely always pail in comparison to the data available to the dealerships themselves, particularly those that operate many brands across many markets. That’s why I find it so valuable to tune into the earnings calls from these companies because they get reports from on the ground relating to the day-to-day changes in supply and demand that shape the industry as a whole.What goals do you have when it comes to working with auto dealerships?David Harkins: I’d like to cover every brand. There isn’t an equal number of dealerships by brand across the country, and some are more prevalent than others. Some may also have different valuation needs than others. While there are some brands I’ve worked with numerous times, there are a few I have not yet had the opportunity to work with. I’ve worked with all the domestic brands and have even been exposed to numerous high-line brands. But there are still a few mid-line import brands and luxury brands that have eluded me.

June 2022 SAAR

Quantifying Pent-Up Demand

The June SAAR was 13 million units, up 2.3% from last month but down 16% compared to June 2021. This month's release closes out the second quarter of this year, bringing the total Q2 2022 SAAR to 13.4 million units. Q1 2022 SAAR of 14.1 million units was already considered low compared to pre-pandemic, and the last few months have analysts wondering if the total 2022 SAAR will manage to exceed the first quarter's sales pace at all. It would certainly take a major turnaround in the second half of this year for the 2022 SAAR to normalize by the time it is all said and done.As far as unadjusted sales figures are concerned, June 2022's performance can be put in a more appropriate perspective when compared to the last seven years of June releases (See the chart below). June 2022's unadjusted sales pace narrowly outpaced June 2020, but compared to 2015-19, the unadjusted sales pace over the last month is significantly depressed. Even when compared to June 2021, a month where high demand intersects with dwindling supply for only the second month in a row, the June 2022 SAAR still comes up short. The story behind the slow sales pace remains the same in 2022 as it was this time last year, but to a magnitude that no one expected when we wrote our June 2021 SAAR blog. A lack of available inventory continues to be the largest factor limiting sales. According to Wards Intelligence, inventory at the beginning of June was down 25% from this time last year and was less than a third of pre-pandemic levels. See the chart below for a look at the industry inventory to sales ratio, which has been trending lower and lower since the inventory shortage began to take hold around March 2021. Alongside inventory tightening, other recent trends in the auto industry have also intensified. For example, incentive spending per unit continues to fall, reaching $930 this month (59.4% lower than this time last year). As incentive spending per unit falls, sticker prices have risen. According to J.D. Power, the average transaction price per vehicle was $45,844 over the last month, an increase of 14.5% from June 2021. Furthermore, as a result of climbing sticker prices and rising interest rates, the average monthly payment that consumers are paying for new vehicles has climbed to$686, an all-time high. While almost all consumers that are financing vehicles are feeling the sting of high monthly payments, a growing share of new car buyers are now paying over $1,000 per month. According to a recent WSJ article, over 12% of new car buyers are signing up for monthly payments in excess of $1,000, a much larger proportion of buyers than many would guess. Due to this shift in the environment for the auto consumer, the relative inelasticity of purchasing a new vehicle is being highlighted now more than ever.Pent-Up Demand – What Does That Really Mean During the Auto Inventory Crunch?In several of Mercer Capital's auto blogs (most recently last week's blog) as well as other industry commentaries, there have been references to the idea of "pent-up demand." Pent-up demand has become commonly accepted as a reason for the relative price inelasticity of new vehicles. Inelasticity is the economic concept that a large change in the price of a good, results in a small change in the demand for that good. Pent-up demand can also be predictive. For example, many people following the auto industry have been predicting that once sticker prices eventually "normalize", then many folks that would have bought a vehicle in a more price-friendly environment will finally pull the trigger and make that new vehicle purchase. With prices still climbing and dealers still selling through most all of the inventory they get immediately, we're seeing that some consumers aren't able to wait for a more favorable buying environment.What will "normalized" volumes look like after supply chains recover? From 2015-2018, light vehicle sales in the U.S. exceeded the threshold of 17 million, which has been bandied about as the new normal. Expanding the lookback to 2014-2019, average annual light vehicle sales were 17.1 million, and it has become common within the industry to assume that a return to normal after the pandemic and chip shortage will carry the SAAR back to those levels, if not higher (due to the pent-up demand mentioned earlier).However, is a speedy return to a 17 million unit SAAR a reasonable expectation? And is 17 million even the correct number?We can look at the historical volumes to answer these questions. See below for a chart of the SAAR from 1976 to the first half of 2022. We have included a trend line to show the overall trend of upward movement during this period.It is easy to see that the market for new vehicles has been increasing over time. Population growth and the shift from 1 car households to 2+ car households are two obvious reasons to explain the upward growth of new vehicle sales. It is also easy to see that the market for new vehicles is cyclical. A period of elevated sales is typically followed by a down period where the demand for autos dips due to an economic recession or just general softening of demand. The last period where we saw this occur was centered around the credit crisis in the late 2000's where OEMs particularly struggled. This recovery was also compounded by storms in Asia in 2011.From 2013 to early 2020, the new vehicle market could be characterized as being in an up-cycle. SAAR figures being reported during that period may not have been unsustainable from the perspective of OEMs or dealers. Still, a general softening of demand was bound to happen at some point. While population growth and more vehicles per household lead to a general uptick, OEMs have improved the useful lives of new vehicles as well.However, an organic softening of demand was not allowed to take its natural course due to the COVID-19 pandemic and the resulting supply chain disruptions associated with it. The 17 million units sold prior to the pandemic are above the line of best fit in the data set. With population growth and increases in the number of new vehicles per family, we believe a linear line of best fit is appropriate for the data set. The formula on the graph shows each year, 184 thousand more vehicles are sold than the previous year. It also estimates volumes of about 16.6 million in 2022, which looks very unlikely at this point. While this long-term view is not a good predictor for sales next month, particularly in light of supply chain constraints, we believe it reasonably supports that sustainable sales levels may be lower than the 17 million achieved pre-pandemic.Extrapolating forward with current data, 17 million in annualized volumes wouldn't be anticipated until April 2025. It will be interesting to see how this data changes in the coming months if/when supply constraints are removed. All that being said, perhaps a return to the long-term trend is the most reasonable assumption that industry experts can make. Based on the trend line in the chart above, a normalized SAAR of 16.5 million seems to make sense. While the difference between a predicted 17.5 million unit SAAR and a 16.5 million unit SAAR certainly does not make the largest difference in the grand scheme, it is important to have a more nuanced discussion around what "normalized" sales are going to look like in the wake of the inventory crunch that is gripping the industry in 2022.July 2022 OutlookMercer Capital's outlook for the July 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

State of the Industry From the Tennessee Automotive Association Convention

Musings From Mercer Capital’s Music City Office

Last week we attended the Annual Tri-State Convention for the Automotive Associations of Tennessee, Mississippi, and Alabama. The event provided a great opportunity to discuss trends in the automotive industry with industry participants and dealers from different manufacturers and geographic areas. In this post, we discuss some of the trends discussed last week, including a variety of topics that we have covered before in this space. We also incorporate highlights of a presentation from noted industry analyst Glenn Mercer (no affiliation with Mercer Capital) regarding the "Dealership of Tomorrow."Supply and PricingAs the last few publications of the monthly SAAR figures (April and May) have indicated, the production of new vehicles by auto manufacturers and suppliers to auto dealerships continues to be impaired by a variety of economic factors.In fact, analysts from Cox Automotive have recently tempered 2022 estimates of new vehicle sales to 14.4 million units, from their original estimate of 15.3 million units. The average annual SAAR for 2016 through 2019 was approximately 17.2 million units. Using this figure as an estimate of the average demand in the United States, the lost sales caused by COVID-19, the microchip crisis, and continuing production issues will total approximately 7.9 million units from 2020 through estimates for 2022.Even if auto manufacturers are able to scale production back to pre-COVID levels plus some excess to account for this pent-up demand, full recovery and stabilization could take 3-4 years.Glenn Mercer forecasts that annual demand should continue at the 17 million unit average through 2030. While we find this reasonable, we plan to delve into this topic further in a future post. With demand exceeding supply for the last several years, auto dealers have continued to capitalize on higher margins for new vehicles. According to Cox Automotive, the average transaction price for new vehicles climbed to $47,148 in May 2022. One byproduct of these trends is that some auto dealers have been able to sell new vehicles for a higher price than the manufacturers' suggested retail price ("MSRP"). As the following chart indicates, the average customer-facing transaction price has exceeded the MSRP for the same vehicles since the fall of last year. The question on most dealers' minds that we spoke with is how long are these trends sustainable? With the rising costs of vehicle transactions coupled with general inflation and rising gas prices, how long will consumers be able to afford new vehicle purchases at these levels? As the chart below indicates, the median number of weeks of income needed to purchase a new light vehicle has risen dramatically to 41.3 weeks in April 2022, fluctuating between 32-36 weeks for the prior decade. This figure will probably continue to climb as average transaction prices rose in May and are expected to climb again in June. Click here to enlarge the imageDemographics of Number of Dealerships and OwnersWith all of the headlines of heightened transaction volume in the auto dealer M&A market and increased activity and investment by the public auto groups, we find two charts from Mr. Mercer's presentation to be informative, which we have attempted to combine for comparative purposes: store count and owner count.We have written numerous times about the resiliency and adaptability of auto dealers and the entire automotive industry during challenging economic times. Despite the challenges, the number of auto dealerships or stores in the United States has remained relatively stable at around 18,000 since 2009.While store count has largely remained unchanged, consolidation has occurred in the owner count. Factors contributing to the decline in the number of owners include the retirement of aging owners, increased size and profitability of the average dealership, and the aforementioned activity and appetite for acquisitions by the public and larger auto groups.The following chart displays the declining owner count from its previous high of just over 10,000 in 2008. While we expect there may be further industry consolidation, conventional wisdom is that this reduction will continue to come in the form of fewer owners than fewer stores. However, as we discussed with Tony Karabon in a recent post, ownership counts may not continue this downward trajectory with the appetite displayed by first-time buyers. Auto dealerships are attractive investments, and many dealers offer a minority equity stake in dealerships as part of the compensation package for GMs. We'll be curious to see how this trend evolves because regardless of who owns the dealership and how many they own, someone still has to run each one. And after you own a piece of an attractive investment, you tend to want one all for yourself. While larger groups benefit from their scale, there are limits to how large OEMs will allow their dealers to grow, and there is an appetite from smaller buyers looking to get involved.Future Impact of Fixed Operations on Auto DealershipsAnother hot-button topic discussed at the Conference was the continued speculation that OEMs might shift to an agency model or direct sales to consumer model, which could decrease the auto dealers' portion of profits from new vehicles. In some discussions, the auto dealers' participation might shift to a delivery center whereby the dealer would receive a delivery fee if the customer selected that particular dealership to pick up their new vehicle.These changes could lead to physical changes at a dealership if there are no longer requirements to house and showcase new vehicles. If costs can be removed from the sales and distribution model and shared in a mutually beneficial way, it may not be the worst thing for dealers, though most are reasonably skeptical.Regardless of the prospects of a changing share of new vehicle profits, dealers would be wise to refocus on their fixed operations, specifically parts and services. Fixed operations have historically been a stabilizing segment for successful dealers. Even with heightened vehicle sales profitability, fixed operations remain the highest margin for a typical dealership, though their contribution to total gross margin has declined with higher GPUs.One trend lost in the shuffle of higher profits is that auto dealers' percentage of the total parts and service market has actually eroded over time to independent and after-market repair centers. These alternative options have climbed in recent years, and consumers often cite their convenience and reluctance to the dealership experience as reasons for their selection.The following chart illustrates that dealerships' total parts and service market percentage has generally declined since 1955, hitting an all-time low of approximately 30% in 2020. The bay and outlet count of the various types of parts and service outlets are as follows. Dealers should strongly consider offering some versions of mobile service or potentially satellite locations to mitigate the locational and convenience factors of the aftermarket alternatives in an attempt to recapture some of this market and high-margin business. And if the industry moves more toward an agency model, there may be fewer bad memories from the purchase experience that could negatively impact the likelihood of capturing after-sales work. We can even envision a situation where OEMs do more to push consumers back to the dealers for service work in order to make up for a decreased role in the sales process. In the transport refrigeration business, it is more difficult for consumers to get repairs from non-dealer repair shops. With increasingly complex light vehicles with all the microchips being used and features being added, it's possible service and repair work will naturally shift back towards auto dealers.Electric VehiclesThe other widely discussed topic continues to be electric vehicles (EV). Industry participants all have their predictions based on early adoption rates, government subsidization, and other factors. While adoption rates are still relatively low, (EVs are ~5% of the market), Mr. Mercer predicts this penetration figure could reach 8% by 2025, but full-scale adoption could be years off.The agency model discussions above have really picked up due to EVs. On the face of it, the sales method doesn't depend on the vehicle's powertrain, whether an internal combustion engine (ICE) or EV.While adoption remains relatively low, there is a clear stratification in the marketplace as current EV buyers tend to come at the upper end of the market. These buyers are less likely to have low credit scores, have negative vehicle equity on their trade-ins, or have any other complications that generally push would-be online car buyers to the dealership for more help in the sales process. These buyers are also generally willing and able to pay for this convenience, so a top-down approach from the manufacturer to sell vehicles to this top end of the market makes more sense than the franchised distribution model utilized when sales become more complicated.Political Considerations of Electric VehiclesOne factor impacting the adoption of EVs may be politics. As seen from the survey conducted by Strategic Vision in 2020, more Republicans purchase trucks and SUVs, while more Democrats have historically purchased alternative powertrain vehicles (APTs), including hybrid electric vehicles (HEVs) and battery electric vehicles (BEVs). It will be interesting to monitor the success of Ford's Lightning (which recently had a recall for low tire pressure warnings) and other EV truck offerings to see if they break these political buying trends and lead to quicker adoption of EVs. Other constraints against EV adoption have also been the battery life and difficulties with public charging stations. While the entire infrastructure of public charging stations would need to be built out with the continued adoption of EVs, consumers currently list the following barriers to their experience in areas where more charging stations currently exist, such as San Francisco: membership requirements, operability issues, price, payment issues, and locating a convenient charging station location. Full-scale adoption of EVs can also lead to other geopolitical factors. Just as the Russia-Ukraine conflict has made us aware of the industry's dependence on Ukraine as a chief exporter of neon that is used in the production of microchips, many of the components in the batteries for EVs are exported from China. The following is a list of some of the key battery components and the share of processing volume by country in 2019: Click here to enlarge the imageConclusionsThe recent Tri-State Convention (Tennessee/Alabama/Mississippi) provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It's informative to hear how individual dealerships are confronting their own unique challenges.All of the trends/factors discussed in this post will continue to impact the operations of dealerships and, ultimately, their profitability and valuation. We thank Glenn Mercer for his informative talk and him allowing us to reproduce many of the graphics in this post.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

An Overview of Auto Finance

Credit Risk, Trends, Used vs. New Vehicle Sales

Auto dealers that sell new vehicles around the country rely on their Finance and Insurance (F&I) departments as an important source of earnings. While top-line revenue in these departments is typically a small portion of a new car dealership’s total revenue mix, these departments have much more favorable margins than their counterparts in the selling division. For used dealers without subsidiary captive finance operations, third-party lenders take a larger role in the financing process and the economics tends to be different than their new vehicle-selling counterparts.In this blog post, we examine the layout and current state of the auto finance industry as well as quotes from public auto executives pertaining to the current financing environment.What Is the Layout of the Auto Finance Industry?The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles. Sales financing establishments are primarily engaged in lending money for the purpose of providing vehicles through a contractual-installment sales agreement, either directly from or through arrangements with auto dealers. Industry participants generate revenue through the interest and fees that are included in the installment payments of borrowers.The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles.There are two major types of auto finance operators: captive finance companies and third-party lenders:Some examples of captive finance companies are Toyota Financial Services, General Motors Financial Company, Honda Financial Services and BMW Group Financial Services. These companies are “captive” to the larger OEM’s leadership and have less decision-making autonomy. The purpose of these captives is to provide the parent company with a substantial source of profit and also limit the company's risk exposure. Captive finance lender loans are typically exclusive to new vehicles.Third-party lenders like Ally Bank, Capital One, Chase, Wells Fargo, and Truist provide insurance and financing to dealerships and their customers that primarily sell used vehicles or new vehicle dealerships without a captive finance subsidiary. Consumers can also decide to use a third-party lender in place of a captive finance company on purchases of new vehicles as well. Banks are not the only entities that participate in the auto lending industry. Credit Unions, Specialty Finance companies and “Buy Here, Pay Here” (BHPH) companies also lend to car buyers. (It is important to note that BHPH companies may hold the consumer’s loan on their balance sheet or sell the loan in the open market. Thus, these companies have attributes of captive finance subsidiaries as well as third-party lenders.) See the graphic below (Source: Piper Sandler) featuring auto finance lenders in different industry classifications. It is easy to see how the different classes of lenders outlined in the graphic above might have different risk tolerances and return targets. For example, the “Buy Here, Pay Here” companies are more likely to lend to subprime borrowers. While these companies have taken scrutiny for charging higher interest rates on said borrowers, they are undoubtedly taking on more risk while demanding a higher return in response. Additionally, the cost of repossessing vehicles is endemic to their operations, not a “normalization” adjustment that one might consider in the valuation of a new vehicle dealership.State of the Auto Finance IndustryExperian releases a “State of the Automotive Finance Market” webinar on a quarterly basis. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2022. A summary of these trends follows.Origination TrendsOver the last three Q1’s, around 60% of total vehicles financed were used vehicles.Retail volume is down in 2022. Using January as an example, 3.48 million units were financed in 2022 compared to 4.22 million and 3.89 million units in 2020 and 2021 respectively.The market share of total financing has shifted a bit in the past year, with banks and credit unions capturing bigger pieces of the auto finance pie when compared to captives and Buy Here, Pay Here operators. Captives gained some market share following the onset of the Covid-19 pandemic as banks tightened underwriting standards, but banks have recently regained their position.The average credit score by vehicle type has been consistently increasing since the first quarter of 2017 for both new and used vehicles. (Q1 2022: 736 for New and 669 for Used) These scores compare to Q1 2017’s 725 and 644.Prime borrowers (buyers with credit scores between 661-780) made up just over 64% of total financing, while subprime borrowers made up around 17%. The most substantial growth in originations over the past quarter has been with prime borrowers.Despite rising trade-in values, the average amount financed has also been on the rise. The average amount financed and the average monthly payment were $39,450 and $648, respectively in Q1 2022.Portfolio Balances and DelinquencyOverall loan balances grew to $1.37 billion in Q1 2022.Delinquencies have ticked up over the past year. Auto loans that are 30 days delinquent grew from 1.46% of total loans to 1.55%. Auto loans that are 60 days delinquent grew from 0.51% of total loans to 0.59%.Independent, used dealers are seeing the highest rates of delinquency. As discussed above, this is part of the normal course of business for BHPH operators. As prime borrowers are flocking to new car loans and delinquencies on these loans remain low, subprime used car buyers are beginning to show signs of financial stress. Rising sticker prices and monthly payments are the most likely cause of an uptick in delinquencies.Public Auto Executives Chime In – Sonic AutomotiveIn our Q1 Earnings Calls blog, we touched on a theme that came up throughout this quarter’s public auto exec interviews: affordability. Many of the franchised, new vehicle-selling dealers downplayed affordability concerns, which is consistent with what we have seen in the trends outlined above.Heath Byrd, CFO for Sonic Automotive, when asked about new vehicle affordability concerns, said that:“What we’re seeing from a macro perspective is there’s not any material impact to the prime and near prime consumers. […..] Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, what you’re starting to see [is] a little bit on the lower income, but on the upper tier we’re not seeing anything material.”Jeff Dyke, President at Sonic Automotive, echoed these concerns around used vehicle affordability:“The problem is, is that we’re pushing $500 a month payments, and we used to pay $400 a month payments, and it’s too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it’s always run 50% to 55%, somewhere in there. It’s at 70%. It’s too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That’s just not — that’s out of the norm.”With a lack of new vehicle affordability, buyers are increasingly bidding up used vehicles. The explosion of companies like Carvana, Shift, Vroom, etc. has exacerbated used vehicle demand, lifting prices above historical norms, further squeezing subprime buyers.ConclusionRising rates and record levels of inflation may put auto purchases out of reach for some lower income consumers and create hardships for those trying to pay down existing floating rate notes that weren’t locked when interest rates were low. Facing the possibility of a recession and deteriorating credit quality, auto lenders will likely adopt more conservative lending practices and credit portfolios linked to auto loans may trade at steeper discounts to par to recognize the increased risk. While this could impact vehicle sales in the case that would-be buyers are unable to obtain the financing they need, as we’ve seen in the past two years, vehicle demand tends to be pretty inelastic. Ultimately, those focused on prime borrowers seem to be on solid footing for now while lenders with more exposure to subprime borrowers may start to experience more difficulty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Valuation and M&A Trends in the Auto Dealer Industry

Let the Good Times Roll?

A few weeks ago, Scott Womack sat down with Tony Karabon of DCG Acquisitions to discuss trends in the auto dealer industry. Tony is Managing Director with DCG Acquisitions. Prior to joining DCG, Tony spent 24 years as the Vice President and General Counsel for two large dealership groups.DCG Acquisitions is a national, full-service mergers and acquisitions firm representing buyers and sellers of automobile dealerships. DCG Acquisitions is part of the Dave Cantin Group of Companies along with DCG Capital and DCG Media.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. Our firm has an Ownership Accelerator Program which assists first-time buyers in acquiring dealerships. We have had many success stories with the program, so the number of dealership owners might not shrink quite as fast as some are predicting. 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.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.History has shown that dealerships are good investments, and this is the business dealers know best.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.The agency model and electric vehicles encompass a multitude of potential issues.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 DCQ 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.

May 2022 SAAR

Can Auto Dealers Continue to Outperform OEMs?

The May 2022 SAAR was 12.7 million units down 12.6% from last month and down 24.9% from May 2021. This month’s SAAR did not meet expectations, and the dip in May’s sales pace increases the likelihood that the second quarter of 2022 will not improve on the first quarter’s average SAAR of 14.1 million units. May’s SAAR was low due to limited inventory around the country, which is not news to anyone following vehicle markets over the past year.Vehicle production around the world has been constrained by the lack of manufacturing components available to auto manufacturers. The ongoing invasion of Ukraine, as well as globally lingering COVID-19 related effects, have come together to create a very tough environment for manufacturers to meet the demand for new vehicles (check out our March SAAR blog for insights into Ukraine’s impact on auto manufacturing). While most March and April forecasts reflected the impact of Russia's invasion of Ukraine, updates in May to these projections addressed some additional challenges that have arisen, including a slow recovery in semiconductor supplies, the impact of further COVID lockdowns in China, and the longer-term influence of high raw material prices that put added pressure on new vehicle affordability. In short, May was a month that the production sting was sharp. One example is Toyota, which announced a 10% global production cut in May, citing tightened lockdowns in China.In the U.S., transaction prices remained elevated throughout May, with dealers reporting an average transaction price of $44,832 per vehicle, an all-time May record and up 15.7% from this time last year. Likewise, incentive spending per vehicle has continued to fall, with NADA estimating just $965 per vehicle over the last month. Like new vehicles, trade-ins continue to demand higher values across the country, providing buyers with increased equity in their existing ride to mitigate climbing monthly payments. In May, the average monthly payment on a new vehicle contract was $687, another record high. The Fed’s two rate hikes in the early months of 2022 have not helped the affordability of monthly payments either. J.D. Power reported that the average interest rate on a new vehicle finance contract in May was 4.92%, up 62 basis points from May 2021.Have Higher Interest Rates Hurt Auto Manufacturer Stock Prices?Higher monthly payments on new vehicle financing contracts are not the only impact that rate hikes have had on the auto industry. Domestic manufacturers like the Big 3 (Ford, Stellantis, and GM) have seen their share prices decline, though this drop in market cap was not exclusive to OEMs, as losses were observed throughout the United States economy across many growth-centric industries like technology and data science. The S&P 500 is down 13.3% in 2022 (see chart below). The Nasdaq 100, a technology-heavy index, is down 23.0%. The Dow Jones Industrial Average is also struggling, down 9.5% on the year. An auto manufacturer has not traditionally been considered a “growth company.” In the last decade, that moniker has been reserved for the Apples, Microsofts, and Facebooks of the world. A growth industry is a sector of an economy that experiences a higher-than-average growth rate as compared to other sectors. Growth industries are often new or pioneer industries that did not exist in the past, and their growth is a result of newfound demand for products or services offered by companies in that field. Growth companies may carry large interest-bearing debt balances that finance the research, implementation, and expansion of their products and services. This means that, for a growth company, an increase in the cost of debt could make growth that much more expensive. Tesla (TSLA) is a great example of a growth company. Tesla, which boasts a spot among the highest valuations in auto manufacturing, has benefitted from a changing regulatory environment and the emergence of new electric vehicle technology. From the perspective of Ford, Stellantis, and General Motors, it makes sense to begin investing in similar technologies to cash in on the growth story and unlock higher multiples and valuations, which is exactly what these companies have sought to do. On March 2nd, Ford announced it would boost its spending on electric vehicles to $50 billion through 2026, up from its previously announced $30 billion. In July 2021, Stellantis announced $35.5 billion in investments toward electric vehicles through 2025. Likewise, General Motors released its own plan in 2021 to invest $35 billion through 2025. With the Big 3 committed to significant EV investments over the next five years, there is increased execution risk with delivering vehicles that fulfill the promise of EVs that benefit consumers without representing a trade-off between fuel efficiency and performance. To the extent these investments are financed by debt, the rising cost of financing may drag on profitability. Pushing returns further out into the future also tends to reduce valuations as interest rates rise, as seen in the decline in tech stocks. While the stock price of a public company is subject to exogenous forces outside of the realm of what may impact the valuations of closely-held businesses, the private markets ultimately are impacted by the public markets. See the charts below for a look into the stock prices of Ford, Stellantis, and GM compared to the timing of rate hikes by the Federal Reserve in 2022: OEMs are also likely to see share price declines due to continued production cuts and rising input costs. A decline in the share price does not necessarily affect the company's operations directly, but there are less direct impacts on manufacturers which executives keenly observe. What do lower valuations of OEMs mean for auto dealerships across the country? Over the long-term, OEM executives are not likely to tolerate sluggish shareholder returns while auto dealers are making record profits. While OEMs are down with the market as discussed earlier, it’s important to note that the publicly traded auto dealers are generally worth more than they were to start the year, a sharp contrast. With talks of an agency model growing ever more present, it appears that there will be changes to the current landscape. Hopefully, these changes will benefit all interested parties including OEMs, dealers, and consumers.June 2022 OutlookMercer Capital’s outlook for the June 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Long term, it will be interesting to see how the landscape evolves and whether OEMs try to wrestle a greater share of profits from their auto dealer partners. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership

Q1 2022 Earnings Calls

Large Dealer Groups Continue to Invest in the Franchise Dealer Model, Managing Their Dealerships as Portfolios

There continues to be no end in sight for new vehicle supply constraints. So much so that it's taken as a given, and there was less direct mention of inventory shortages in 2022's first quarter public auto dealer earnings calls. Despite this shift, scarce inventory remains the key theme underpinning the operating environment for auto dealers.Demand continues to exceed supply across all OEMs. For example, Lithia Motors noted it started a month with 13,000 vehicles and ended with 12,000 vehicles but was still able to sell over 24,000 vehicles. We've seen this with our auto dealer clients, and it really brings into focus what Days' Supply consistently under 30 looks like. When dealers are selling nearly double the inventory on their lots, it will take a long time before inventories can build back to pre-COVID levels. And with higher profits for dealers and OEMs, we may not ever reapproach those levels.Even more so than last quarter, there are a couple of interesting nuggets that don't quite fall into themes that were noteworthy. For example, much has been made about the future of electric vehicles and the impact on auto dealers. There have been concerns about a shift towards an agency model and conventional wisdom has been that EVs would generate less service work for dealers. Asbury's VP, Dan Clara, challenged that notion this quarter with the following:"My belief is the propensity or the frequency of [EVs] coming to the shop will be less. But the time in dollars will be greater, not just what they spend, but what we end up charging because of sophistication to work at it. And putting electric aside and not talking about autonomous, there are some technology features in cars today, braking where your car can break with someone in front of you, lane changing, the shifting and learning you. That's all technology that could have bugs in them. So while the cars really get heavy content with technology, not just the battery piece, it allows for more opportunity for things to go wrong. And when you talk about driving a 5,000-pound vehicle at 60 miles an hour down the road, there's a lot of liability in touching those cars. So you've really got to be thoughtful and think about what you're going to do over the [airwaves] that are nice to have and what you're going to do that may have a real liability issue in driving the vehicle."So, while he acknowledges there may be fewer ROs, dealers stand to potentially increase their pricing power for more complex work while also taking market share from less sophisticated body shops. As we've noted before, a significant amount of repair work is not performed by auto dealers at present, which provides an opportunity if the shift in powertrain steers more consumers back to the dealership. Fixed operations have generally improved as vehicle miles traveled increase and people continue to return to the roads. However, a depressed SAAR since 2020 has held back warranty work for many public auto dealers.While the themes presented below touch on M&A and large auto groups seeking to manage their investment in dealerships as a portfolio, Roger Penske discussed the benefits of open point locations, which are amplified in this low inventory environment:"On an open point, they have a plan that says this is the planning potential for a point, let's say, it's 1,500. And what they will do is preload you with those cars when you-- before you open and you get those for about, I think, probably about 90 to maybe 180 days, but then you're on a run rate based on your history. So it works out well. And I think -- after spending $15 million or $20 million on a facility, you certainly need the cars to start the business. I think it's certainly good for future allocation because you continue to meet the requirements of the planning potential and to give you the cars or trucks to be able to meet that early on. So it's up to you to drive it, and then maintain it."Here are the major themes from the Q1 2022 Public Auto Earnings Calls:Theme 1: CarMax kicked off earnings season by attributing a decline in its used car volumes to affordability issues. Affordability became a common question of the franchised dealerships due to this statement, particularly as interest rates rise. While Penske acknowledged that affordability likely had some impact, other companies tended to downplay any concerns."Inflation is never good for the consumer, but clearly, it's going to hit the lower demographic sectors of the market first. And there is such a massive gap and has been such a massive gap for the last 18 months between supply and demand. But first of all, demand would have to come down on new vehicles a long way before it got anywhere close to supply. […] And our core customers, while it may be not ideal, we just don't have data that shows that that we're seeing less activity in our stores yet." – Earl Hesterberg, President and CEO, Group 1 Automotive"What we're seeing from a macro perspective is there's not any material impact to the prime and near prime consumers. Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, that you're starting to see a little bit on the lower income, but on the upper tier that we're not seeing anything material." – Heath Byrd, CFO, Sonic Automotive"And then, there is some affordability issues there which are going to have some impact on margin. But from an overall standpoint, the demand is strong, we're selling into our pipeline from the standpoint of our new car business, and sequentially in our units are up from 101,000 to 114,000. If you look at Q4 to Q1, so we're not seeing it at the moment that we're having any impact negatively at this point. – Roger Penske, Chairman & CEO, Penske Automotive Group"The demand is there. I'd disagree with the comment made a few weeks ago. I don't think that's accurate. There's still plenty of demand. There'll be 37 million to 40 million cars sold in America this year in terms of pre-owned. So, the demand is there. The problem is, is that we're pushing $500 a month payments, and we used to pay $400 a month payments, and it's too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it's always run 50% to 55%, somewhere in there. It's at 70%. It's too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That's just not -- that's out of the norm and that's what's causing someone to maybe think that there's not a demand there. – Jeff Dyke, President, Sonic AutomotiveTheme 2: With the backdrop of framework agreements, large public auto groups are managing their stores as a portfolio, seeking to optimize by brand and geography. When certain OEMs only allow a certain number of stores per auto group, they are more selective about the markets in which they choose to operate their finite number of dealerships."We'll continue to monitor the M&A market as we believe there are potential opportunities that would enhance our already strong dealership portfolio. […] We have the ability through relationships today to go out and purchase another $5 billion if we wanted to today. Our goal is not to grow quickly. Our goal is to grow thoughtfully and be great capital allocators for our shareholders. So I think that the timing, cadence and pace is important. I think the states where you've seen us grow in our thought process of balancing the brands with the right states, you won't see us differ from that and acquisitions going forward will be accretive for us. The one thing I don't think our space gets a lot of look at is portfolio management. What do they buy? What do they sell? What did that do from an accretion standpoint? Not from a top line revenue, but what did that really do to them as a whole? And so I think you'll see us really manage the portfolio well. You'll see more divestitures over time, probably at some point in the future. And you'll certainly see more acquisitions as well. But that's just really maximizing the portfolio to generate the highest returns and create the most stable company for our employees and our shareholders." – David Hult, CEO, Asbury Automotive Group"I think most importantly, we always optimize our network to make sure that it's clean. We bought stores over the years that, that were in groups typically that weren't right for Lithia and it's a matter of divesting those. I believe it was annual run rate of about $90 million were sold in the quarter. And a number of those were assets that we just don't believe were to some extent salable okay and in this environment, everything is kind of salable. So we took advantage of that and divest of those stores. And you'll see, you'll probably see more of that in the next few quarters. You probably have a half a dozen stores that are typically smaller stores may be located in an area where it's not helping our network at all, meaning, it's a duplicate store, secondary store or it's into smaller market where you're utilizing a General Manager talent and you can reposition them in a better and bigger store." – Bryan DeBoer, President and CEO, Lithia Motors"We signed up for framework agreements probably, what, 10 year sago, there were some with some like Honda, Lexus had it, and we've lived with those over time. Now they are getting more active now when you look at BMW and other of these manufacturers are coming in now with probably not as much to try to curtail the growth but more to be sure that the dealerships that you already have are meeting the CSI requirements, and the CI and the market performance. And that's what they're looking at before they would allow you to grow. […] I don't think they're saying no. In fact, if you're a good dealer, and you've got a good track record, they [only] limit you to [a] number in a particular market, so you're not the only dealer in the marketplace. I think other than that, they're very appreciative when we come to them with an opportunity because they know we've got the capital, we've got a track record. We've got a management team that many of them know. And I've seen you've seen the growth just in the public, and they've been approved with big acquisitions. Now in some cases, you might have a market where you have to sell something off. But I think that is easy. I mean we made a move from Lexus in New Jersey to buying the two Lexus stores in Austin, and we had to divest the two to get two more. But obviously, I looked at the Jersey market versus the Austin market, and feel, on a longer-term basis, it would be a better opportunity for the Company." – Roger Penske, Chairman & CEO, Penske Automotive Group"We're in a cyclical business, right? So obviously for me I like the blend that we have in terms of brands. I think it's a really good blend particularly when I think through the plan for the individual OEMs are put in place, because ultimately the product that they are working on today really is going to dictate the success on the new car side of the business going forward. Firstly, I am encouraged by the level of investment has been made. And secondly, it doesn't really change my view on the balance that we have in our portfolio today. I think it just reinforces we have a good balance. – Michael Manley, CEO, AutoNation"It's a timing situation. We were competing to buy LHM. We didn't know who we're competing against and didn't know we were getting the deal. The Stevinson deal […] came together quick. We didn't want to pass on that opportunity not knowing if we're going to get the Miller organization. Then fast forward, we signed Stevinson and then we got the Miller one. So we knew we had an issue because the manufacturer has a limit to how many stores you can own and reach in. So we knew that we would have to sell some stores." – David Hult, CEO, Asbury Automotive GroupTheme 3: The franchise dealer model is alive and well. Multiple companies emphasized vehicle acquisition as the key to performance in used vehicles, and a primary driver is trade-ins when customers purchase new vehicles."We continue to focus on the acquisition of the inventory. We all know that is in used cars, where the return is generated. Close to 85%, 86% of our acquisition is coming through the consumer, whether it is in the form of our leased earnings, trades or buying cars through -- directly from the consumers." – Daniel Clara, SVP and CFO, Asbury Automotive Group"As we all know, success in the used car market is dictated by your ability to manufacture great quality, well priced desirable used cars and this clearly covers key elements of the business, including efficient and effective reconditioning for example, but it all starts fundamentally with your ability to competitively acquire used inventory and with strong consumer demand we continue to focus on our self-sourcing capabilities for used vehicles, which I think further strengthened both our franchise dealerships but also our AutoNation USA businesses." – Michael Manley, CEO, AutoNation"We're a different business than CarMax or Carvana and some of these used car retailers. Because, number one, we've got a large parts and service business, which covers 60% to 70% of our fixed costs. We also have OEMs that we're tied to would give us an area of market that we operate in. And they provide us with all the umbrella advertising to drive customers, both new and used to our stores, and then we have the relationship with the captive finance companies. And then, the lease returns that are coming in give us in the future when the cars are available for additional use. So looking at that, taking that as really a base to work from, we've got a short supply of new cars, which is driving used car prices up. And certainly, our acquisitions have been very tough at the moment when you think of about just looking at CarShop in the U.S., in the UK and the U.S. are our cost of sales up $8,500 [per unit] and the UK is up [$4,400 per unit]. And when you add that on to the existing number, it's really pricing us on the U.S. side, up into almost new car numbers." – Roger Penske, Chairman & CEO, Penske Automotive Group"As a top of funnel, new car dealer that gets to used vehicles coming in on-trade. We're making about $1,900 more on vehicles that come in from consumers than that we buy at auctions or from other dealers and we turn that much faster. So it's a huge advantage that we have […] a pipeline of inventory coming in quickly on the used car side." – Chris Holzshu, EVP & COO and CEO, Lithia MotorsConclusionAt 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.

Smart Connected Cars, OTAs, and Their Impact on Auto Dealers

The Future of Automobiles

Lost in all of the headlines surrounding electric vehicles is another trend that has emerged in automobiles over the last several years: Connected Cars.The presence of connected features transitions the car (or light-weight truck) from just a vehicle getting you from point A to point B to a computer-like device with customizable technology features, making the trip an experience. Just as mobile phones and appliances have gone from single-function devices to smart devices, so have cars.(Why the moniker "connected" cars, and not "smart" cars. With apologies to the discontinued venture between Swatch and Mercedes Benz, the term "smart" car has historically been synonymous with a compact, fuel-efficient design.)In a previous post, we discussed the future of auto dealerships and how they will be affected by inventory shortages and electric vehicles/direct selling.In this post, we examine the size and growth of the connected car segment and discuss the struggle between auto manufacturers/OEMs and auto dealers over servicing these features.Connected Cars and Size of the MarketConnected cars are vehicles with their own connection to the internet, usually through a wireless local area network (WLAN) that enables the vehicle to share data with other devices inside and outside the vehicle.Connected technology features can include satellite-navigation systems with traffic monitoring capabilities and remote features that utilize smartphone apps such as starting the engine, warming or cooling the car, or locking/unlocking the car. In theory, connected cars could also communicate with other smart products opening up a whole new world of possibilities.These features are not without limitations in the current automobile manufacturing environment. As we have discussed on this blog, automobile manufacturers have faced numerous production challenges including COVID-related plant shutdowns and, more recently, shortages of microchips due to supply chain issues. Modern automobiles continue to use more microchips for features such as emergency brakes, back-up cameras, and airbag deployment systems. Not to be overlooked, microchips are also used in connected features such as touchscreens and are present in engines to improve engine efficiency and lower emissions.There were 84 million connected cars on the road in 2021 compared to ~3 million electric cars. And the number of connected cars is estimated to grow to 305 million by 2035.What is the size of the connected car segment and how does that compare to the size of the electric vehicle (EV) market? According to estimates by Hedges Company, there were approximately 286.9 million cars registered in the U.S. in 2020. The figure was expected to climb to 289.5 million by the end of 2021. Most prognosticators estimate that the number of electric vehicles on the road in the U.S. is less than 1% of the total cars, SUVs, and light-duty trucks. Using these figures, total electric vehicles would top out at less than 2,895,000.By contrast, Statista estimates there were 84 million connected cars on the road in the U.S. in 2021. Based on the numbers and despite all of the headlines about electric vehicles, the majority of connected cars would be traditional ICE (internal combustion engine) vehicles. Over the last few years, all major OEMs have been introducing new models with connected features. According to projections by Statista, there will be over 305 million connected vehicles on the road by 2035 in the U.S. alone.Size of the Global Connected Car Fleet in 2021, With a Forecast for 2025, 2030, and 2035, by RegionSource: StatistaThis implies that while EVs are expected to be a growing percentage of future vehicles produced, the vast majority of vehicles being produced today are connected cars.OTAs and Service DepartmentsLike smart phones and smart appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air updates (OTAs). An OTA is a software improvement or upgrade that is sent from an OEM or industry software company directly to the vehicle through a wireless internet connection.We are all familiar with technology updates sent to our phones that most of us initiate at night so we can wake up to their successful completion and implementation (if we remember to keep them on the charger). With connected features in automobiles, the technology is very similar. OEMs or product manufacturers can deliver updates or communicate directly with these features in times when the software is not working properly.Auto-related OTAs are usually grouped into two broader categories: infotainment and drive control. Infotainment refers to the touchscreen and features that combine information and entertainment to improve the in-vehicle experience. Examples of infotainment include maps/navigation, phone calls, and Bluetooth connection, music, and podcasts. Drive control refers to safety protocols to improve the performance of the vehicle such as system enhancements or corrections to powertrain systems, fuel efficiencies and engine emissions features, and advanced driver assistance systems.This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. Will other states follow?Drive control features are typically less noticeable to the average driver. For perspective, MARKETSANDMARKETS estimates that the size of the global infotainment market is $20.8 billion and is expected to grow to $38.4 billion by 2027, at a compound annual growth rate (CAGR) of 10.8%. Another study by Acumen Research and Consulting estimates the entire global automotive OTA update market will grow by a CAGR of 18.1% through 2028.What are the advantages to OTA updates?Less or no in-person recalls – For software-related issues on connected features, an OTA could eliminate the need to visit the dealer.Cost Savings – Vehicle owners can save time and money without having to visit the dealer, and OTA updates could mean significant savings for automakers in labor costs.Additional Features – With OTA updates, certain features on the vehicle will continually be improved, potentially leading to a slower depreciation rate on aging vehicles.Safety/Compliance – As new legislation and standards are enacted, such as emissions standards or autonomous driving, OTA updates would be able to address changes in a timelier fashion. What are the disadvantages to OTA updates?Fewer visits to auto dealers – What can be an advantage to a vehicle owner can be a disadvantage to an auto dealer. Service departments in traditional auto dealers rely on service visits to assess and recommend other service items in addition to the primary reason for the visit, such as tire rotations, brake repair, oil changes, and other routine and scheduled maintenance. The service department allows the dealer to maintain an ongoing relationship with the customer through these frequent touchpoints. The service department is historically the most profitable department in the dealership in terms of margin. To spin this positively, happier consumers may lead to more brand stickiness for dealers.Cybersecurity – As with all technology and wireless internet connections, OTAs present risks of technology malware and theft or exposure of personal information. Who will seek to capture and monetize the OTA update market? Just as Tesla has been the poster child for innovation and technology in the electric vehicle market, they have also implemented OTA updates as part of their operating strategy and ongoing revenue. Will the traditional OEMs try to monetize and capture some of the market through a subscription model, and will it be at the expense of auto dealers? A few other key players in the automotive OTA updates industry are Airbiquity, Continental AG, Blackberry QNX Software, and Hitachi, among others. We recently attended the Spring Conference of the National Auto Dealer Counsel (NADC), and the topic of OTAs was discussed in a session presented by NADA. Specifically, Andrew Koblenz shared that the OEM's strategy regarding technology revolved around three premises: improving the overall customer experience through such measures as single price selling, driving efficiency and eliminating unneeded costs, and optimizing downstream revenue opportunities through OTAs. Perhaps the "right to repair" battle over OTAs is just beginning to intensify. This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. The provision was later dropped as part of a larger bill. It will be interesting to see if other states will seek to address OTAs or whether OEMs and auto dealers can share the same vision for the increasing number of connected features in automobiles and how these features will be serviced and maintained.ConclusionConnected cars are here to stay. We will continue to monitor the issues presented by connected cars and their impact on auto dealerships. In the meantime, feel free to contact a member of the Mercer Capital auto dealer team today to discuss a valuation issue in confidence. Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members in understanding the value of their business.

Case Review: Observations From a Recent Auto Dealer Litigation

A recent Appellate Court decision was released from a case (Thomas A. Buckley v. Grover C. Carlock, Jr. et.al.) that we were directly involved in back in 2019. The case centered around a shareholder oppression issue involving a minority owner of an “ultra-high-line” auto dealership. Mercer Capital was hired by the Defendant to serve as the expert witness.The company at issue, TLC of Franklin, Inc. (“the Company”), was an official auto dealer for Aston Martin, Alfa Romeo, Lotus, Maserati, Rolls-Royce Motorcars and Bentley. The valuation aspect of the case required both experts to determine the fair value of the oppressed shareholder’s 20% interest in the Company as of January 31, 2017.The Appellate Court upheld and affirmed the Trial Court’s determination of value of the 20% interest. A summary of each expert’s valuation opinion and the Court’s conclusion of value is as follows: The nature of the Company’s underlying operations created several valuation challenges in this case. First, the unique set of the brands offered by TLC, that are referred to as “ultra-high-line,” is not as prevalent in auto dealerships across the country. Among the nearly 17,000 auto dealers in the U.S., there are very few that retail the premium brands offered by TLC of Franklin. Because of this, there is little published data on these franchises – from details of their historical profitability to market multiple representations of their value in transactions. The other challenge presented in this case was that the Company’s historical operations did not report consistent profitability during the reviewed period. In this post, we highlight the differences in the assumptions and conclusions of both valuation experts, as well as provide observations regarding some of the commentary provided by the Trial and Appellate Courts in arriving at the ultimate conclusion of value. We also touch on normalization adjustments, valuation methodologies, and the way in which the Court decided its determination of value.Normalization Adjustments to EarningsWhat Are Normalizing Adjustments?It is important in the valuation of an auto dealership to review the company’s financial statements to determine if any normalization adjustments should be made. Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Typical normalizing adjustments to the income statement are made to non-recurring items, as well as discretionary expenses related to current management that would not necessarily be incurred by a hypothetical owner of that business. As mentioned previously, the actual historical operating performance of the Company was inconsistent during the reviewed period. In some years, the Company reported operating losses, making the determination of these adjustments difficult.The Experts’ Application of Normalizing AdjustmentsThe experts disagreed with respect to the magnitude of normalization adjustments, though they agreed such a normalization adjustment would be necessary. For example, after directly identifying several adjustments to earnings, Mercer Capital selected a 1.5% normalization factor of pre-tax earnings-to-revenue based on the Company’s actual operating performance, similarly sized auto dealerships, and our experience valuing luxury and ultra-high-line dealerships. The Plaintiff’s expert determined a normalization factor of 5% of pre-tax earnings-to-revenue based on their experience valuing ultra-high-line dealerships.The Trial Court’s DeterminationThe Trial Court selected a normalization factor of 2.8% - 2.9% of revenue based upon historical data for 2015 and 2016 as published by the National Auto Dealers Association (“NADA”). Specifically, the Court cited annual historical profitability for “Luxury” and “Import” brands noting they were the best comparison to TLC of Franklin. Until October 2021, NADA published monthly profitability data referred to as Dealership Financial Profiles for categories of auto dealerships, including average, domestic, import, mass market, and luxury, and the Trial Court relied heavily on this data.The Use of Industry Comparable DataThe use of comparable data to compare a subject company to industry averages can be important to the valuation process. While NADADealership Financial Profiles is more specific than general industry profitability data, such as the Annual Statement Studies provided by the Risk Management Association (“RMA”), no single comparison is perfect, and appraisers should be careful in applying average percentages to their subject company.The use of comparable data to compare a subject company to industry averages can be important to the valuation process.TLC’s ultra-high-line brands were not included in the descriptions of the NADA Dealership Financial Profiles classifications, even among luxury dealerships, despite connoting a similar type of consumer. In reality, the representative average data in these studies is comprised of many dealers performing at higher or lower levels than the ultimate average. A rigid comparison to the average could potentially ignore the fact that the subject company has been performing below average since its operation or in recent history.The other caution against a rigid normalization adjustment to an industry benchmark is the implied level of the resulting adjustment. In other words, by normalizing a company to a certain % of pre-tax earnings, what is the resulting dollar amount of the adjustment? Take, for example, a company with revenues of $35 million. To normalize earnings to a 5% pre-tax earnings level would imply that there are $1,750,000 of expenses to be normalized or added back.The Plaintiff’s expert offered no evidence or specific expenses that would rise to that level in their review of the historical financial statements. Mercer Capital determined several normalization adjustments to earnings after reviewing the Company’s financial statements and discussions with management before making an overall normalization adjustment of 1.5% of earnings based on our experience with similar dealerships to TLC.Valuation Methodologies UsedIncome ApproachThe income approach is a general way of determining the value indication of a business or ownership interest using one or more methods that convert anticipated economic benefits into a single present amount. The income approach allows for the consideration of characteristics specific to the subject business, such as anticipated earnings, level of risk, and growth prospects relative to the market.Mercer Capital ultimately determined the value of the subject interest through the use of a capitalization of earnings method. Historical earnings were adjusted through a combination of direct normalization adjustments and an industry adjustment to 1.5% of revenues. The resulting value under the income approach represents the overall value of the dealership, both tangible and intangible. The difference between the overall value of the dealership under the income approach and the value of the dealership’s net tangible assets represents the implied value of the dealership’s intangible or Blue Sky value. Therefore, Mercer Capital’s income approach included and quantified the Blue Sky value of TLC.The application of the income approach assumes that the company possesses the appropriate level of assets and liabilities to produce the level of anticipated earnings in the income approach. Only non-operating or excess assets are added to the value determined under the income approach. For example, some dealerships carry much more cash than needed for operations before eventually distributing it to owners. In such cases, the excess cash is added back on top of the indication of value under the income approach.Mercer Capital did not identify any non-operating or excess assets owned by TLC. Therefore, no assets were added to our conclusion of value under this approach.The Plaintiff’s expert did not employ an income approach in his determination of value.Market Approach – Recent TransactionsOne method under the market approach is to examine any transactions within the subject company's stock. Appraisers will often examine whether any transactions have occurred, when they occurred, and at what terms they occurred. There is no magic number, but as with most statistics and data points, more transactions closer to the date of valuation can often be considered better indicators of value than fewer transactions further from the date of valuation.Three transactions occurred within the stock of TLC in the three to five years prior to the date of valuation. A summary of those transactions and their indicated equity values are as follows: The Plaintiff’s expert used the internal transactions as one of his three valuation methods but only relied upon the first and third transaction in the figure above. All three transactions occurred in relatively similar proximity but obviously indicated materially different implications of overall value. Ironically, the second transaction that the expert excluded involved the plaintiff’s buy-in to the company. The third transaction involved a minority sale to a celebrity, and no evidence was provided as to the motivations of the buyer and seller in that transaction or whether any financial information or due diligence was performed by the buyer. As such, it may be reasonable to consider this transaction less reliable as an indication of value than the other two. The first transaction was for a 75% interest, which represents a controlling interest basis, which is a different level of value than the other two transactions. Since the subject interest is non-controlling, the level of value would be more comparable to the last two transactions in the table above.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. Suppose there have been multiple internal transactions, such as with TLC of Franklin. In that case, appraisers must determine the appropriateness of which transactions to include or exclude in their determination of value possibly. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to consider all of the transactions or exclude all of the transactions with a stated explanation.The Trial Court was critical of the Plaintiff’s expert’s exclusion of transaction #2 and noted the material impact it would have on concluded values.Mercer Capital observed the internal transactions of TLC but did not place any reliance on this method.Market Approach – Blue Sky MethodUnder the market approach, the Blue Sky method determines value by applying a brand-specific multiple to pre-tax earnings. This method estimates the intangible value or franchise rights of the specific brands they retail.Blue sky multiples are published quarterly by two sell-side advisory firms in the auto dealership industry: Haig Partners and Kerrigan Advisors. Specific multiples are calculated and presented for each represented brand by quarter based on observed transactions. It should be noted that neither Haig nor Kerrigan publishes any multiples for ultra-high-line dealerships or any of the brands retailed by TLC.The Plaintiff’s expert concluded a Blue Sky multiple of 8x based on reported multiples for luxury brands and applied that multiple to two different income streams. First, he applied the Blue Sky multiple to normalized earnings based on his 5% pre-tax figure described previously. Secondly, he applied the Blue Sky multiple to projected earnings based on figures from a management presentation.The Trial Court was especially critical of the use of projections for TLC since it was not a start-up entity. Projections are rarely used in the valuation of auto dealerships. It should also be noted that no evidence was provided as to where the management projections came from, who produced them, and for what purpose. Blind or rigid reliance on management forecasts should be avoided especially if they are not discussed with management. Projections should be viewed with caution, especially in instances where projected results greatly exceed historical operating results or if the company has historically performed below previous projections or budgets. If projections must be used, appraisers typically account for this by using more conservative multiples to balance these lofty projected earnings.To these approaches, the Plaintiff’s expert added back the net tangible assets of TLC since these methods estimate the intangible value or franchise rights of the brands represented by the dealership.Mercer Capital did not rely on a direct Blue Sky method to value TLC since no published multiples exist for the brands represented by TLC. When applicable, we employ the use of a similar methodology to value dealerships in conjunction with or to support the valuation determined under another method, such as the income approach. The transaction multiples reported by Haig and Kerrigan are derived from negotiations between buyers and sellers. The ultimate consideration paid is determined by the buyer’s assessment of expected cash flows, the growth potential of those cash flows, and the anticipated rate of return. The multiple reflects the price paid in relation to a financial metric, in this case pre-tax earnings.Courts’ Determination of ValueThe Trial Court ultimately determined value through several calculations. The Court utilized the profitability data provided by the NADA Dealership Financial Profiles for luxury and import dealerships for 2015 and 2016 and applied profitability factors of 2.9% and 2.8% to TLC’s historical revenue for those years.The Court concluded the use of an 8x multiple or factor to normalized pre-tax earnings to estimate value for TLC. The Court’s final conclusion of value for the subject 20% interest was $1,745,500. This conclusion included an average of those four calculations along with half of the adjusted net assets to reflect the inclusion of market and income methods. The Appellate Court affirmed the concluded value and methodology used by the Trial Court in this case.ConclusionAs evidenced by this litigation case, the valuation of auto dealerships can be very challenging and complex. The subject company, in this case, provided additional challenges given the unique specialty of the brands that they retail, combined with their inconsistent and lack of historical profitability.Mercer Capital provides valuation services to auto dealers and their advisors all over the country for litigation and non-litigation purposes. Contact a Mercer Capital professional today to learn more about the value of your dealership or if we can assist you in a litigation issue involving the value of your dealership.

April 2022 SAAR

The April 2022 SAAR was 14.3 million units, up 6.5% from 13.4 million in March but down 21.9% from the recent high April 2021 SAAR of 18.3 million units. The last three April SAAR figures (’20, ’21, and ’22) are interesting to compare to one another, as dynamic conditions resulted in three very different narratives surrounding the SAAR.In April 2020, the COVID-19 pandemic had taken its grip on the world economy, stifling the demand for vehicles as economic uncertainty pushed consumers to hold off on vehicle purchases. This pause in activity kept potential buyers off dealer lots despite adequate inventory levels across the entire industry. Cooled conditions resulted in very low sales and a relatively high inventory to sales ratio (3.93) compared to the all-time high of 4.64 in January 2009. It may be hard for some to remember, but dealers were turning as much inventory as they could even at lower GPUs in order to shore up their cash position.In April 2021, demand had more than recovered. Pent up demand from the pandemic was showing its face, resulting in the highest ever recorded level of April raw sales. Inventory balances would have been considered healthy but declining due to strong demand. Sales outpaced the rate of OEM vehicle production.In the current environment, the tables have now completely turned from the observed conditions in April 2020. Demand has continued to stay strong, but historically low balances of inventory have restricted raw sales numbers well below what was observed in April 2021. While there may be some signs or reasons to expect some pullback in demand, it is still overwhelming when compared to historically constrained supply.Thomas King, president of the data and analytics division at J.D. Power shared his takeaways from April: “The April sales pace may look disappointing compared with April 2021, but last April’s record sales pace was enabled by the combination of extremely strong consumer demand and enough inventory (nearly 1.7 million units) to turn that demand into actual sales. This April, demand remains strong, but with fewer than 900,000 units in inventory at dealerships, sales volumes will necessarily be well below year ago levels.” As the last three Aprils have shown us, striking a balance between the number of available vehicles on dealer lots and the demand that exists in the market has been difficult over the last two years and will likely continue to be difficult until the supply/demand dynamics of the auto market align more closely. During the valuation process of several engagements, many of our auto dealer clients have spoken about the sales pace on their lots compared to their limited stock of vehicles. We are seeing that most of these dealerships ended April with just about the same inventory balance as the start of the month while selling at almost a 1:1 relationship between inventory-in and inventory-out. This is due to a high number of pre-order sales, which brings lot-time for these vehicles close to essentially zero days. It is truly impressive that dealers can sell more vehicles in a month than they had sitting on their lots at the start of the month. A sign of the times.Keeping with the trend over the last year, year-over-year growth in profits has been observed as high as 20%, hammering home the fact that dealers continue to thrive in this high price environment. Many consumers may balk at transaction prices that continue to run up the charts, but it is worth noting that the demand for vehicles has seemed much less elastic (sensitive to price changes) than many previously thought. Speaking of transaction prices, the industry average remained elevated at $45,232 per unit, up 18.7% from this time last year and an April record. The all-time record was set last December and there have only been small incremental changes up and down since then.High transaction prices have come alongside decreasing incentive spending per vehicle. April’s incentive spending per unit came in at $1,034, an all-time low. See below for a comparison of the last seven April’s incentive spending per unit: The cost of financing a vehicle has also worsened for consumers as rising interest rates have pushed monthly payments up to an April high of $685. The Federal Reserve, after already having introduced a rate hike in the first quarter of 2021, opted to raise rates by half a percentage point on May 4. This increase is twice the size of a typical rate hike due to the Fed’s aggressive strategy against inflation. The Fed has also announced that it expects to raise rates further over the summer.Despite interest rates adding fuel to the fire, monthly payments are only up 15.6% from this time last year while transaction prices have increased 18.7% over the same period. This can be attributed to longer terms on loans, as 72 and 84 month terms become more commonplace. Lower and middle-income buyers will have to weigh the rising costs of financing a vehicle as affordability challenges limit the options that these buyers have available.May 2022 OutlookMercer Capital’s outlook for the May 2022 SAAR is consistent with the last several months. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value.

Values Up, Valuations Flat?

As the Inventory Shortage Persists, Dealers Are Getting More Credit for Their Outperformance

Pre-COVID and chip shortage, it would be no surprise if Blue Sky multiples remained stable over numerous quarters for many brands. As seen in the charts later in this post, multiples normally don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM.In 2020, the economic shock to the economy borne by the COVID-19 pandemic caused Blue Sky multiples to oscillate in near lockstep, regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples. As the chip shortage and lack of inventory have persisted into 2022, auto dealers are getting more credit for recent outperformance as earnings rise steadily.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the following year. Since the onset of the pandemic, as expectations have been much more dynamic, the earnings stream to determine ongoing expectations has shifted.Throughout most of 2020, Haig’s Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any negative COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Throughout the latter half of 2020, it became clear that the pandemic positively impacted earnings. Most dealers significantly outpaced pre-COVID results, despite a month or two of nearly stand-still operations.In late 2020 and into 2021, Haig reports that buyers were using a three-year average of adjusted profits from 2018, 2019, and LTM ’20 or ’21, or two years of pre-pandemic results and one year of outperformance. The prevailing thought was that the outperformance due to COVID would eventually normalize, and buyers didn’t want to overpay for dealerships that may not be able to repeat these earnings in the future.Now in 2022, Haig reports that buyers are ready to acknowledge that not only have earnings continuously increased, but the inventory shortages show no signs of abating. As we’ve noted for months, industry players have continuously said the situation should normalize in the next 6-9 months. But they’ve been saying that since about February 2021, or 14 months ago.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up.As we sit here today, the outlook is still uncertain, but I personally wouldn’t have extreme confidence to say operating conditions or earnings will normalize in 2022. The lead time to meaningfully increase microchip production is clearly long, and with record profits for dealers and manufacturers, OEMs aren’t necessarily incentivized to change the status quo. Demand for personal vehicles is certainly more inelastic than the market previously indicated.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up. With earnings steadily increasing, Blue Sky values have followed the same path. That’s why it’s important to understand what level of earnings are being applied to the multiple.Illustrative Example: HondaTo show the path of Blue Sky values since the onset of the pandemic, we’re going to take pre-tax earnings for average import dealerships as reported by NADA and apply them to the appropriate multiple. Last year, we did this analysis for Lexus, so we’re switching from Luxury to Mid-Line Import. We also thought earnings would normalize, yet it has gone the opposite direction in the past year. Unfortunately, due to licensing issues, NADA no longer posts monthly dealer financial data on its website, so our analysis is only based on what we had previously saved, and we must use some extrapolations.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 5.5x to 6.5x for Honda dealerships (tied with Toyota for the highest multiple for import dealerships). With 2019 pre-tax earnings of $1.66 million for the average import dealership, the implied Blue Sky value for the average Honda franchise would range between $9.1 million and $10.8 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $8.3 million to $9.9 million.By year-end 2020, multiples and earnings each increased significantly, and Honda was up to a range of 6x-7x, or $11.1 million to $12.9 million based on a 3-year average pre-tax earnings of $1.84 million. Through a tumultuous year, the multiple landed a half-turn higher than Q4 2019, and earnings were up 39.9%. Even using the 3-year average, “ongoing” earnings at year-end 2020 were up 11.2% from 2019. As seen on the chart above, Honda’s reported Blue Sky multiples have been unchanged since Q3 2020 at a range of 6x-7x. But from Q3 2020 to Q3 2021, earnings more than doubled, and 3-year average earnings increased 51% from $1.67 million to $2.52 million. Multiplying by the mid-point of the range, Blue Sky values increased from $10.9 million to $16.4 million. In Haig’s Q4 2021 report, ongoing earnings are now expected to be based on 2019, 2020, and 2021 earnings. With 2021 performance more than double 2018 earnings for import dealerships, this change in methodology further increases ongoing earnings. Based on our estimate of 2021 earnings, the average Honda dealership would fetch $18.6 million in Blue Sky or double its value from Q1 2020. While the mid-point multiple has only increased from 5.5x to 6.5x, ongoing earnings increased from $1.66 million to $2.86 million.Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership.We consider a hypothetical transaction to further illustrate how Blue Sky values have exploded. If a Honda dealership was sold in January 2021 at the prevailing mid-point Blue Sky multiple of 6.5x applied to 3-year average earnings of 2018, 2019, and 2020, the seller would’ve received just under $12.0 million in Blue Sky. The buyer’s first year of earnings in 2021 would be an estimated $4.44 million, way above the “ongoing” expectation. While nobody expects 2021 performance to be earnings into perpetuity, the implied Blue Sky multiple of that transaction was only 2.7x, or lower than any reported Blue Sky multiple range. While few could predict what would happen in 2021, the hypothetical buyer above was a clear winner. While there are numerous doomsday scenarios for dealers these days about longer-term perspectives, I would think twice before selling my largest investment while at peak cash flows that I felt I had some control over if I wasn’t getting well compensated. Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership. Below, we observe how Blue Sky multiples have changed over the past five years. However, as we’ve illustrated above, the recent lack of movement is not indicative of stagnant Blue Sky values.Blue Sky Multiples: Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range, though as highlighted above with imports, dealership values have taken off. After years of only reporting a value range due to a lack of profitability, Cadillac dealerships are now reported at a range of 3x-4x and will be included in future graphs. This multiple range is in line with Acura as the lowest for luxury dealerships. Despite being luxury brands, 3-4x is the lowest reported multiple range, in line with VW and Mazda, which have had their fair share of struggles in recent years.Blue Sky Multiples: Mid-Line Import BrandsFour of the eight Mid-Line Imports multiples improved in the second half of 2021. In Q3 2021, Kia and Hyundai multiples increased 0.5x to 3.75x-4.75x, further distancing these dealerships from the lower half of the mid-line imports (VW, Mazda, and Nissan) though as seen in the graph below, still well below Toyota, Honda, and Subaru. Nissan’s multiple also ticked up 0.25x in Q3 2021, making it slightly more desirable than VW and Mazda.Toyota was the only brand to see a change in its multiple in Q4 2021, modestly increasing its lead at the top of the group at 6.5x-7.5x. Toyota dealerships now fetch just higher valuations than Audi and Jaguar-Land Rover dealerships. While they don’t sell luxury vehicles, Toyotas are definitely viewed as dependable vehicles which consumers can appreciate. Toyota has also taken a balanced approach in terms of EV adoption, which makes sense for the company that really pioneered the hybrid approach with its Prius in the early 2000’s.Blue Sky Multiples: Domestic BrandsDomestic franchise multiples have not changed in the past year, all generally above the lackluster mid-line imports but well below other players. One would think that supply chain constraints would negatively impact import brands more than their domestic counterparts. However, the past year has demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last five years, Stellantis dealerships have seen their multiples modestly improve, while Ford, Chevy, and Buick-GMC are all down. Only Audi shows a decline in the past five years while Acura, Honda, and Mazda are unchanged and everyone else has seen their multiples increase. While domestic dealerships have not received high Blue Sky multiples, they have been well positioned for the shift from cars to trucks, and heightened earnings across the board is likely to lead to greater return on investment for dealerships that trade at lower multiples.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple. If a dealer feels they are being reasonably compensated, they may choose to sell. As demonstrated in this post, earnings expectations can be significantly different from actual results.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key value drivers. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

March 2022 SAAR

The March 2022 SAAR was 13.3 million units, down 5.3% from 14.1 million in February and down 24.4% from March 2021's SAAR of 17.6 million units. This drop in the SAAR is a product of several factors, one being the low magnitude of the seasonal adjustment. The seasonal adjustment in this month's SAAR is minimal compared to adjustments made in January and February, as March is typically a bigger selling month in the automotive industry (See below for unadjusted total sales numbers).Also pulling the SAAR down is production stoppages, as the production of new cars and trucks continues to be limited in the wake of ongoing supply-chain issues and global shocks from the war in Ukraine. More detail on the specifics of auto supply-chain headlines is included later on in this post.Seasonal AdjustmentTotal unadjusted sales over the past month were certainly low compared to previous years, except March 2020 when the COVID-19 pandemic shook up the world economy. Declining sales are not due to a lack of consumer demand, which has been elevated since mid-2021. In fact, consistently heightened demand for vehicles has kept incentive spending low (all-time low of $1,044/Vehicle) and average transaction prices high (March record of $43,737) over the last month.High sticker prices have increased the average monthly vehicle payment to $658, up 12.4% from this month last year. Rising interest rates in the last several months have compounded the issue, making the purchase of a new vehicle that much more expensive for consumers. Vehicle payments have not increased at quite the rate of sticker prices due to higher trade-in equity values, up 81.3% per vehicle from March 2021.These conditions come as no surprise. When asked about the last month prior to the SAAR data release, Thomas King, president of the data and analytics division at J.D. Power, commented, "Typically, March is a high-volume sales month with elevated promotional activity because it marks the end of the fiscal year for some manufacturers and the close of the first quarter for others. In March 2021, consumers purchased almost 1.4 million new vehicles at retail. This year, with fewer than 900,000 units in inventory, it will be impossible for the sale pace to even approach last year's level. Given the strong demand and extremely constrained inventory situation, it should be no surprise that manufacturer discounts are at their lowest level ever, while prices and profitability set records for the month of March."Industry-wide inventory balances for February were released this month, and they revealed virtually no change from the status quo. The industry Inventory/Sales ratio saw a modest increase, but the uptick was primarily due to decreased sales rather than increased inventory. When looking into the individual components of auto inventory in the U.S., domestic auto production and the number of imported vehicles both decreased, making for an all-around lack of vehicles available to auto dealers and their customers.The War in Ukraine and the Auto Supply ChainRussia's invasion of Ukraine and the resulting economic sanctions and reverberations are the latest global events to rock supply chains. The United States government has talked of reeling back globalization in an effort to reduce dependencies on China and Russia in a number of strategically important industries. President Biden has also announced a release of 180 million barrels of oil from U.S. reserves in response to rising fuel prices, given Russia's place in the oil and gas industry. Furthermore, microchip facilities are under construction across the U.S. as the country makes a concerted effort to become less dependent on off-shore micro-chip producers, which pre-dates the Russian invasion of Ukraine but is certainly relevant. As we've discussed before, there is a long lead time to producing microchips, meaning it will still take a while to increase domestic production meaningfully.Some analysts are projecting around 1.5 million lost units in 2022 as a result of shutdowns, while others are projecting up to 3 million lost vehicles.To focus on the auto industry in particular, automakers are facing their third supply-chain crisis in the past three years. On a global scale, European auto manufacturers like Volkswagen are being forced to shut down facilities. The company released a statement saying that "With the extensive interruption of business activities in Russia, the executive board is reviewing the consequences of the overall situation during this period of great uncertainty and upheaval." The fallout is not limited to Europe either, as Toyota, Ford, and Hyundai shut down plants in response to the conflict and have echoed sentiments of uncertainty. According to the Wall Street Journal, some analysts are projecting around 1.5 million lost units in 2022 as a result of these shutdowns, while others are projecting up to 3 million lost vehicles. The point is that visibility is very low.European OEM facility shutdowns are not the only repercussion of the conflict in Ukraine. Dozens of auto parts makers shut down facilities in the country as well, setting up a ripple effect that could impact automotive plants in every corner of the globe. For example, Ukraine has become a key supplier of electrical wiring assemblies. Western Ukraine is an attractive location for making wiring harnesses and cable assemblies because of the local workforce's relatively high quality and low cost (it is a labor-intensive activity). It is also geographically situated as a hub between manufacturing plants in Germany and Asia. Likewise, many raw materials used in the production of vehicles are sourced from Ukraine. Oil (used in countless processes) and neon gas (used in the production of microchips) are the two most relevant newly restricted raw materials in the automotive industry.There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Logistical issues have also been magnified amid the invasion. Train, plane, and boating connections have been disrupted or halted in the region, adding additional costs to an already elevated logistics pricing environment. There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Another consideration relevant to the automotive industry has to do with trade policy and the global presence of automakers. Since the invasion began, several OEMs like General Motors have gotten out of Russia (financially and physically). The decision to back out of the country came as several corporations across many industries (seemingly) came together to sanction and exclude Russia from economic activity. Many of these companies probably viewed their Russian investments as losing bets once the war started. These actions by OEMs raise an important question: will the doctrine of globalization in auto finally decline after the dust has settled? If that turns out to be the case, will any automakers move back into Russia after the war is over to seize an opportunity?April 2022 OutlookMercer Capital's outlook for the April 2022 SAAR is pessimistic and consistent with the last several months. Industry supply chain conditions continue to worsen and are expected to decline before they get better. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arrival. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Meet The Team

Scott Womack, ASA, MAFF

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Scott Womack, Senior Vice President of Mercer Capital and the leader of the Auto Dealer industry team.While Scott has provided valuation services for clients in a wide variety of industries, he has significant experience in the auto dealership industry. He provides clients in the industry with valuation and financial advisory services for purposes including gift and estate tax valuation, litigation support, corporate valuation, ESOPs, and financial reporting.The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Scott Womack: Initially, I knew I wanted to be in a career involving numbers and problem solving. My introduction to the valuation profession came from my college roommate's father, who is a pioneer in the industry. Ironically, that college roommate and his father are now two of my colleagues at Mercer Capital, Bryce and Don Erickson. After 20+ years in the industry, I still enjoy the challenge of determining the qualitative and quantitative factors that impact the value of businesses.What attracted you to a career in litigation support?Scott Womack: I started doing divorce work about 13 years ago. Personally, I find this work to be very rewarding. Divorce clients are very appreciative and I believe I am making a difference as their Trusted Advisor throughout the process, but especially in mediation or during the trial. Often the non-business (or "out-spouse)" is not directly involved in the couple’s business and doesn’t know the value of the business or understand the process of valuation. These clients look to us to educate them and guide them through the process. Business owners (or the "in-spouse") also see us as a value-add to the process, as they may have not gone through the business valuation process during their ownership of their company.What type of cases gives rise to your involvement in litigation matters?Scott Womack: More often than not, I am involved in family law/divorce cases. The cases generally involve high-wealth individuals and those who own businesses or business interests. In addition to the valuation and forensic work, I also participate in mediation to assist the client in an attempted settlement. If mediation is not successful, I generally submit a formal report to the Court and do testimony work at trial. Other litigation projects include breach of contract or shareholder disputes.How has the valuation industry evolved since you started?Scott Womack: Early in my career, the industry was comprised mostly of valuation generalists. In the early 2000s, financial statement reporting and valuations took on a whole new life of their own with purchase price allocations and stock-based compensation. At this point, the valuation profession kind of exploded to become more specialized. We have people that now specialize in a specific service – be it, say, divorce or financial statement reporting – or a particular industry. So, the movement from generalization to specialization within the industry is the most pronounced change I have witnessed. Especially for growth in your career, specialization is a great avenue for advancement because you are able to become an industry or service line expert.What influenced your concentration in the Auto Dealership Industry?Scott Womack: I had a partner at a prior firm who had several auto clients and I often got to work on those engagements. Some of those engagements were related to divorce so I was able to see what litigation-related valuation is all about. The Auto Dealership industry has some unique characteristics in its financial statements and operations. After being exposed to these differences I saw an opportunity to make an impact in this industry. I am able specialize in this area in order to provide the best valuation services possible.What are a few unique characteristics of the Auto Dealership Industry?Scott Womack: The financial statements are pretty unique in the Auto Dealership industry. Dealers have to submit monthly financials to manufacturers, and each manufacturer statement looks a little different, almost like trying to solve a puzzle. Due to the specialization and profit centers of the various departments, these statements have a lot of detail. They are very informative pertaining to not only the major categories like assets, liabilities, and revenues, but you can also determine the size of the service department or how many used vehicles they sold, what they’re selling them for, or how much inventory they have on the lot. Not only do auto dealerships have to submit monthly statements, but some also report a thirteenth month statement. The thirteenth month takes the twelfth month with added year-end tax adjustments, normalization adjustments, etc. Furthermore, there is unique terminology in this industry. An example would be “Blue-Sky,” which is the goodwill value of the dealership. It can encompass a number of factors and the Blue Sky value is often very meaningful to a dealer requesting a valuation. There are also nuances in ownership and management that are important to know, as well as different valuation techniques and methodologies that are preferred. Someone specializing in this industry is better equipped to know what a client is looking for. My experience valuing auto dealerships has given me an advantage in knowing what to look for and what questions to ask.What types of Auto Dealership engagements do you work on?Scott Womack: Most privately owned auto dealerships are owned in a similar fashion – the operating dealership held in one entity, and the real estate utilized for the dealership location in another entity. I perform valuations of both types of entities for a variety of purposes including estate planning and litigation. We have performed valuations of auto dealerships in numerous states around the country and have been involved in litigation engagements in multiple jurisdictions.What is one thing about your job that gets you excited to go to work every day?Scott Womack: I have always enjoyed that the valuation and consulting business is project-based. On a project basis, you are able to work with different owners and different industries all across the board. One of my favorite parts of a project is conducting the management interviews and site visits. While the financial statements paint a picture and supply the quantitative results of operations, the management interviews provide much of the qualitative factors and allow you to gain an understanding of the company, the industry, and the risk factors that they face. I enjoy meeting different business owners and learning about their successful companies and history.

Public Auto Dealer Profiles: AutoNation

As we discussed in previous installments of this blog series, there are six primary publicly traded auto dealers that own approximately 923 new vehicle franchised dealerships as of year-end, or approximately 5.5% of the total number of dealerships in the U.S. The proportion of the total U.S. dealerships that these publics own demonstrates how fragmented the industry continues to be, despite recent consolidation. For example, in the back half of 2021, there were three significant acquisitions made by public dealers that captured headlines. (Check out our blog from October to explore how these acquisitions might matter to your dealership).Our goal with the Public Profiles blog series is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit from benchmarking to public players. Smaller or single point franchises may find better peers in the average information reported by NADA or more regional 20 Group reports. However, they might still value staying plugged into public auto dealers’ performance. Public auto dealers also give dealers insight into how the market prices their earnings, the environment for M&A, and trends in the industry.AutoNation OverviewAutoNation is the largest automotive retailer in the United States. As of December 31, 2021, the company owned 339 new vehicle franchises from 247 stores located in the U.S. At year-end, the company also owned and operated 57 AutoNation-branded collision centers, 9 AutoNation USA used vehicle stores, 4 AutoNation-branded automotive auction operations, and three parts distribution centers.LocationsAutoNation’s stores are primarily set in the Sunbelt region, but the company has a presence in 17 states. A map of all states that the company operates in with associated percentages of total revenue is included below:Source: AutoNation Investor Deck Fourth Quarter 2021 BrandsThe company sells 33 different new vehicle brands, with 90% of its revenue coming from Toyota (including Lexus), Honda, Ford, General Motors, FCA, Mercedes-Benz, BMW, and Volkswagen (including Audi and Porsche). Comprehensive brand selection is important to AutoNation, as it hopes to provide customers with a broad range of products to choose from. Profit amongst these brands has remained relatively stable over the company’s history. However, in recent years the company has seen a slightly greater profit mix towards selling and servicing higher-margin, luxury vehicles.The company is seemingly brand agnostic, which makes sense given its massive scale and complications with franchise agreements, where OEMs don’t want too many dealerships to be controlled by one company. A breakdown of income by brand from AutoNation’s Q4 2021 investor presentation can be seen below:Source: AutoNation Investor Deck Fourth Quarter 2021 Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if the store and unit-level economics remain similar. Despite these fundamental differences, we should still take a look into some of the financial metrics and trends that AutoNation has observed in its operations over the past few months.There are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer.In the fourth quarter of 2021, AutoNation observed a 13.8% increase in total revenue and a 34.3% increase in gross profit compared to the same period last year. This asymmetric growth can be attributed to margin expansion as rising vehicle prices have benefitted the company’s selling operations. Remarkably, while sales prices have increased faster than the cost of the vehicles, OEMs are also more profitable, which demonstrates why public players want some of the status quo to remain the same once the chip shortage abates. AutoNation’s net income and EPS margins have expanded as well, with net income increasing by 78.3% over the year and EPS increasing by 137%. Changes in the individual components of the company’s income statement are broken down below:Source: AutoNation Investor Deck Fourth Quarter 2021 Like most of its public and private counterparts, AutoNation has achieved an impressive financial performance in the midst of lower retail units sold and historically low numbers of units on lots. Day Sales Outstanding is an appropriate metric to show the magnitude of the inventory shortage’s effect on AutoNation. Throughout 2021, the company’s Days’ Supply dropped from 42 to 9, which is even more notable considering that sales volumes are also declining, which all else equal raises Days’ Supply. Used vehicles bridged some of the gap for AutoNation; as new retail units declined 20% due to manufacturer supply shortages, used vehicles increased by 21%.AutoNation’s finance and insurance department also performed well in 2021, as higher margins on service contracts and increased product penetration resulted in gross margin expansion in the business segment. Parts and Service also saw an increase in gross profit, primarily due to growth in customer pay, internal reconditioning services, and the sale of wholesale parts.Across AutoNation’s four revenue segments, margin structure differences allow for variability between each segment’s revenue contribution and gross profit contribution, as can be seen in the company’s investor presentation and below:Source: AutoNation 2021 10-K AutoNation USAIn 2021, AutoNation’s capital allocation focused on its rollout of AutoNation USA, an exclusively pre-owned sales venture that the company is launching to target additional market share in the used vehicle market. Unlike Lithia that is actively acquiring new vehicle franchises, AutoNation, like Sonic, is investing in a network of used-only stores to compete with Carvana, Vroom, Shift, and other online retailers. They have the built in benefit of sourcing trade-ins when customers come to AutoNation’s new vehicle franchises as well as the scale of their vast dealer network. AutoNation is targeting to have over 130 AutoNation USA stores in operation from coast-to-coast by the end of 2026, and has already launched 5 pilot stores, all of which were profitable. Of the 130 targeted openings, 12 stores are expected to open in 2022. Given they only have 9 currently, getting to 130 will take a significant investment in 2023-2026. If they stick to these plans, there may not be significant capital allocated to acquiring more new vehicle franchises.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on AutoNation. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then their Blue Sky value per share is approximately $109.55. Given recent outperformance, Haig Partners prescribes a 3-year average to determine ongoing pre-tax income. Using this methodology and applying the 24.1% effective tax rate implied by AutoNation’s financials, its ongoing pre-tax earnings per share would be $9.20 or 9.05x Blue Sky.Source: AutoNation Investor Deck Fourth Quarter 2021 While this is relatively in line with all of its public counterparts, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential and its tilt towards luxury brands.ConclusionAutoNation is a good proxy for the entire auto dealer industry in many ways. While the company is regionally clustered in Florida, California, and Texas, it has a presence in and is a product of several unique markets across the entire United States. Its presence in these states also isn’t random; these are three of the four most populous states in the country. AutoNation also sells almost all of the major domestic, import, and luxury brands, further emphasizing the very broad nature of its operations. Financially, the recent historical performance of AutoNation follows many of the same trends that privately held dealerships have been seeing over the past year.At Mercer Capital, we follow the auto industry closely to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers gives us insight to the market that may exist for a private dealership. 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.

Succession Planning for Auto Dealers

Sorting Through the Madness

March is one of the best months on the sports calendar for avid and casual sports fans. Last week, the NCAA College basketball tournament began. Most of us have been checking our brackets to see which games we picked correctly and which upsets have destroyed our brackets. There’s a reason they call it March Madness. Who would have predicted that St. Peter’s would beat Kentucky? The tournament and the bracket challenges are an opportunity to unite friends, co-workers, and family members in a spirited competition. But, they can also be a source of frustration with stumbling blocks at unexpected terms. In many ways, succession planning can leave auto dealers with the same fears and confusion over the process and some of the decisions made along the way.What is succession planning? Succession planning is the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner with wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created.This post discusses some of the key factors involved in the succession planning process and why they are so critical.Cost of a Business Valuation One of the first steps in the succession planning process is to determine the value of the auto dealership. Often there can be a difference in the expectation of value. In other words, there may be a perceived difference in value when assessed by a third party versus the owning dealer. The cost of obtaining a business valuation can also be a stumbling block to the succession planning process. Most valuation professionals will offer different levels of service based upon the strength of the conclusion, the level of procedures performed and the information analyzed, and the style of the report. While it may be more cost-beneficial to engage a business valuation professional to perform limited procedures, a formal valuation is the better course of action. If decisions are ultimately made to transfer the auto dealership in some estate planning tool, a formal valuation will help protect the integrity of that transaction or transfer. In other words, if the transfer was ever to be audited or challenged by the IRS, a formal business valuation serves to justify the indication of value used in the estate planning process. Besides the formal event requiring the valuation, a business valuation can also benefit auto dealers for other reasons. A formal business valuation can be useful to an auto dealer when examining internal operations. While the business valuation represents an estimate of value at a certain point in time, the value can also be examined relative to the business over time. An auto dealer may use additional valuations to evaluate the performance of the dealership over time to assess its performance relative to a budget or long-term plan. Valuations can also give auto dealers insight into the value drivers of their dealership. Auto dealers can continue focus on areas of strength that contribute to value, while also addressing other areas of weakness that may be detracting from value. Finally, a business valuation could serve to evaluate the dealership relative to its peers and competition.Who Should Perform the Business Valuation? The selection of the business appraiser is critical to the succession planning process. A quality business valuation will not only determine the value of the dealership, but also provide a well-reasoned report to explain the basis of value and the underlying assumptions. Further, the valuation assists the auto dealer and their advisors in an understanding of how the dealership is valued. As we’ve written in this space before, dealers and their advisors should select a business appraiser that is properly qualified and credentialed. Additionally, the auto dealer industry is unique from other industries due to its unique financial statements, terminology, and specific valuation methods. When selecting a business appraiser, you should also seek a firm or individual that has experience in the auto dealer industry.Timing of Decision-Making Auto dealers have to face many daily challenges and operational decisions. Chief among them in the current environment, what is my new vehicle inventory and where am I going to obtain additional new and used inventory? Decisions that can be made tomorrow, such as succession planning, may be shifted to the back burner. However, these decisions should be made sooner rather than later. First, unexpected events can impact the value of your auto dealership or the succession planning process. We have focused more on the value of the dealership in this blog post, but succession planning also refers to the transfer of leadership with key employees. A life-changing event to the owner or the departure or thinning of key leadership over time can also impact the value of the dealership.In the current environment, the profitability and implied values of auto dealerships are at record highs.In the current environment, the profitability and implied values of auto dealerships are at record highs. Most prognosticators believe those trends will continue in the short-term due to inventory constraints. For auto dealers that have seen the value of their dealership climb in recent years and the expectation that those values could climb even further, why not consider transferring some of that value to your family? With annual gifting amounts being fixed, auto dealers could transfer more ownership at lower values today than retaining those shares in an appreciating climate. While there has been a lot of talk about estate planning and tax law changes since the change in administration, no material changes have been enacted as of yet. Changes could still be on the horizon.In addition to annual gifting, the lifetime estate and gift tax exclusion is set to sunset in 2026. The current exclusion allows for individuals to transfer $12.06 million ($24.12 million for a married couple) without being subject to estate taxes. These levels are set to drop by almost 50% in 2026. Auto dealers can transfer considerably more value under the current exemption levels today, than if those levels are reduced in 2026.Ultimate Decision The current environment in the auto industry has placed many auto dealers at a crossroads in terms of their ultimate decision: should they consider transferring the dealership to the next generation or should they sell? High profitability and high blue sky multiples for most franchises translate to heightened valuations. The evolution and adoption of electric vehicles forces many dealers to contemplate the additional expenses and challenges that will come with retailing and servicing these vehicles. Further, consolidation in the industry by the public companies and larger private auto dealership groups forces the smaller auto dealer families to compete with companies that have much larger resources and economies of scale. What decision should auto dealers make? Some of the decision revolves around the expectation of value discussed previously in this Blog. Does the dealer’s perception of value equal reality? If the dealership is worth less than what a dealer expected, perhaps it makes sense to retain the dealership and improve operations and improve certain value drivers to eventually increase the value of the dealership. If the dealership is worth more than the dealer expected, perhaps it makes sense to consider selling the dealership at a time of heightened value.High profitability and high blue sky multiples for most franchises translate to heightened valuations.The other critical factor to succession planning, and in this case, transferring the ownership of the dealership to the next generation or key employee, is to assess the existing leadership talent in the business. Is there a second generation of the family that is currently involved in the dealership and familiar with the operating environment? If not, is there a key employee that could step in and continue the legacy of the dealership? In either case, an auto dealer must consider whether either of these individuals would be approved by the OEM. The OEM has to approve the dealer principal of an auto dealership. This consent is not always guaranteed and presents another unique element to the succession planning process for auto dealers.ConclusionAt Mercer Capital, we perform valuations of auto dealerships for owners and advisors all around the country for a variety of purposes. Additionally, 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. If you are contemplating succession planning with your dealership, contact a professional at Mercer Capital to discuss your valuation needs in confidence.

Q4 2021 Earnings Calls

Inventory Shortages Continue to Dominate the Auto Dealership Operating Environment

There continues to be no end in sight for new vehicle supply constraints. In past posts we have noted how executives keep kicking the can down the road, guessing things will normalize in 6 months or so, which they’ve been saying for the past twelve months. Group 1’s management team was refreshingly honest on the situation as detailed in the quote below.“I have been unable to predict on [when inventories normalize] with any accuracy at all. I continue to be shocked. And every month seems to delay the recovery another month. Clearly, no one is building inventory still. […] It seems that there are some issues beyond chips as well now with COVID interruptions and shipping interruptions […] I can’t even keep track of all the stated reasons. But it would certainly seem the first half of the year is going to remain with severe new vehicle inventory shortages. I don’t know what will happen in the second half of the year.” – Earl Hesterberg, CEO of Group 1 AutomotiveInventory shortages are at the forefront of many of this quarter’s themes. While dealers across the country are looking to increase their new vehicle inventories, used vehicles are in greater supply. Numerous executives noted they are carefully managing this inventory to avoid getting burned on currently elevated prices. All the publics (except Lithia) explicitly mentioned a hope that inventories would increase to a new normal, that is below pre-pandemic inventory levels. Executives also seem to generally believe that GPUs will normalize with inventories, though a push for market share by industry participants may further shrink GPUs once inventory is available.On February 15, Edmunds released research indicating 82% of car shoppers paid above sticker price in January. While there have been reports of dealers charging above the manufacturer’s suggested retail price (“MSRP”) since mid-2021, the practice has proliferated and analysts sought comment on the topic this quarter, which was generally denounced for various reasons, again with Lithia being the exception.M&A was not as big of a topic of conversation as in prior calls, though it does still come up. The current M&A market for dealerships is similar to the market for the vehicles they sell: values are elevated above historical norms. As a result, dealer principals may be more interested in testing the waters on what they could get for their dealership. Most executives and dealer principals acknowledge that recent strength in new vehicle grosses should normalize whenever inventories normalize (we’re still waiting). Still, if dealers think the price is right, they may be willing to sell if they can get anywhere near a “normal” multiple on these heightened profits.Private dealers testing the waters on the Blue Sky for their dealership reminds me of Zillow’s “Make Me Move” feature that they recently discontinued. Homeowners on the fence about selling used to be able to post a high price, and if they got traction, they may decide to sell, avoiding the potential penalty of having your home listed for a significant amount of time, which leads to price concessions or actually discourages would-be buyers assuming something “must be wrong” with the house. Bringing it back to vehicles, I recently tested what offer I’d get on my 11-year old vehicle and was pleasantly surprised as it was considerably above its pre-pandemic value.When it comes to M&A for the public automotive retailers, they continue to focus on brand and geographic fit. An interesting nugget came from Sonic that may be interesting to smaller market dealers. While 2021 was the year of the mega-deal, Sonic noted its large RFJ acquisition (which was one of the mega-deals) primarily operates in smaller markets. While the company previously would not have been interested in buying such dealerships, the success they’ve seen thus far means they are open to more tuck-in acquisitions of dealerships in smaller markets, a welcome development for such dealer principals.A couple of other interesting pieces didn’t quite make their own theme. Penske threw cold water on the adoption of EVs, noting that 98% of its sales have been ICE over the past three years, and while OEMs have committed to more EV models, Penske believes it will take “longer than people expect” for widespread adoption, largely due to costs of EVs. Regarding discussions about direct-to-consumer sales, he also called attention paid to startups like Rivian “overblown.” Penske also holds more used vehicle inventory than Asbury, AutoNation, Group 1, and Sonic.Lithia also holds more used vehicle inventories than its peers and as noted previously, and doesn’t have a problem with charging over MSRP. Curiously, its executives also began positioning the company for an environment without franchise laws as it suggests the industry could move towards an agency model with its manufacturers by 2035 (see page 18 of its investor presentation).Theme 1: While dealers are looking forward to more normal inventory levels, they believe there is something to be learned from the heightened profits in the last year: auto dealers are hoping “normalized” inventory levels will be considerably below pre-pandemic levels.“So we don't want 60-day supply inventory. We don't need more 45-day supply inventory. They could just get it back to the 20 and 30-day supply you got great demand, great margin, and it sets up '22 and really '23 for just to be fantastic years for the industry. – David Smith, CEO, Sonic Automotive“The OEMs have become more sophisticated in that regard. And they understand that too much inventory is bad for us and we're not going to take it. And it's bad for them too. And that lesson is really being driven home right now to the OEMs as to the cost of excess inventory. The distribution channels in both the US and UK have been overstuffed for a decade or more. And now that they get leaned out, you can see what it does for the OEM profits also. It's much better for them. And so I think we're going to be in a much better position going forward.” –Earl Hesterberg, President and CEO, Group 1 Automotive“I have to believe that given all the learning through the pandemic and supply and demand dynamics that we've recently seen and the clear messages coming from the manufacturers, we will not return to the excessively high inventory levels that depressed new vehicle margins for both the dealers and the OEMs. […] And the levels of profitability for both OEMs and dealers clearly show the benefits of selling vehicles at MSRP. And what a concept, right, selling at MSRP.” –Michael Manley, CEO, AutoNation“When you look at the floor plan support, you look at customer support, and you look at the incentives that are being paid over the traditional years where we had normal business, the OEMs are digging deep in their pocket. Now they’ve seen a real benefit by backing that off. In fact, I think that’s helping them look rationally down the road that will help them find the R&D that’s going to be necessary when we look at electrification. So hopefully, they got a taste of that. And that will be a slow return and they’ll keep the day supply in the 30 to 45 days and we won’t obviously be where we are today in single-digits. But I think we can manage that carefully brand by brand.” –Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 2: Whenever vehicle inventories normalize, vehicle profitability is expected to normalize as well, though some executives cautioned an attempt to grab market share could further depress heightened GPUs. Notably, Lithia’s base case assumes vehicle profitability fully returns to pre-pandemic levels.“Well, I would hope no one would ever go over 50 days again. And, of course, historically the domestic has always had well over that because of these -- the big variation on the build combinations of full-size trucks and things like that. But for decades Toyota dealers have operated well below 30 days and never missed that much business as far as I could tell. So I think most brands can operate in 30 days to 40 days. And hopefully there will be a corporate memory that the OEMs also can see this benefit and try to manage that way as we go forward. However, any time these large auto companies start fighting for market share that's when the discipline can erode." – Earl Hesterberg, President and CEO, Group 1 Automotive“It's a competitive world and you never know what someone is going to do to try and gain market share and grow their business. I think everyone's learned from the concept that we can be effective with a lower days supply and everyone can benefit from that. Does that mean we'll stabilize at a 35, 40 days supply compared to a 65 or 70? I think it's too early to tell.” –David Hult, CEO, Asbury Automotive Group“Total vehicle GPUs returning to pre -pandemic levels. […] Every day it does seem like the window for increased elevated margins are probably there for longer than we all would like or our consumers would like, but it may be that they don't return to some normalized level” – Bryan DeBoer, President and CEO, Lithia MotorsTheme 3: Used vehicle prices have runup even as compared to the price increase of new vehicles. Public auto dealers are trying to avoid being left holding the bag as the company holding too much used vehicle inventory when the music stops."It's hard to tell but we see the values starting in November, December, have adjusted meaning that they're not growing exponentially as they were before. And until the inventory levels, our belief is until the inventory levels for new cars somewhat stabilize, the used car valuation is going to remain where it is right now. And I don't -- we don't believe that when there is a correction that it will be an immediate correction. It's going to be a gradual correction. So -- but we do believe that is going to be dependent on the new DSI.” – Daniel Clara, SVP and CFO, Asbury Automotive Group“We're sitting at a 36-days supply [on used vehicle inventory…] What you worry about is the rest of the market out there that might have a 60, 80, 90-day supply, they're still sitting on cars that they paid at the height of the market, they're going to have issues. […] It's the price point, right? That's pushing demand up for new cars really because the used car price points are so high and that's got to give. And it's going to give. I mean that's going to happen. Used cars are not -- like I said earlier, are not going to continue to appreciate. We do believe we're starting to see the depreciation cycle start, if the last six weeks are any indication of that.” –Jeff Dyke, President, Sonic Automotive“The used market obviously is super dynamic. We're able to keep the inventories at the level they are because of our -- we changed our sourcing model. And the good thing about the PRUs is, we manage our inventory very tightly. So, any changes in the pricing environment we can react very quickly. I don't know when it's going to change. I feel like it's going to change at some point this year, but I don't know when.” – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveTheme 4: In the high-priced environment, more dealers are charging above MSRP or requiring customers to buy add-ons in order to get the vehicles they want. OEMs generally denounce the practice, as did some of the public auto dealers. Generally, the practice is viewed to leave consumers not trusting the dealer community.“We've seen a number of comments about vehicles being sold above MSRP, quoting the potential adverse impacts on brands and customers, which I understand. And by the way, last year, less than 2% of all the new vehicles sold by AutoNation were above MSRP. But this discussion on MSRP branded customers actually also adds to my optimism regarding new vehicle margins going forward. Because I think it's equally clear that significant discounting and high incentives can also damage a brand, which is another reason for our industry to balance appropriately supply and demand, and another reason why we may expect higher new vehicle margins than we have historically seen pre-COVID. […] I think where the issue is where you've got a short-term temporary disruption and your supply and demand curve in, what I would call, general market, mass market vehicles, where there is no history in these mass market vehicles of used prices going significantly above for a long period of time against new vehicles. And I think that is where you have to be incredibly careful.” – Michael Manley, CEO, AutoNation“We're pressing very hard for them not to bring inventory levels back to pre-pandemic levels. And so margins are going to stay high. The margins prior to the pandemic are low. We should be selling cars at MSRP. I mean this industry needs to get away from doing all the negotiating it’s a hell of a lot less complex, much easier, and it brings the right value for the vehicle. […] I just don't see margins coming back going back to pre-pandemic levels ever.” –Jeff Dyke, President, Sonic Automotive“However, our inventories are still tight and led to a majority of units being presold. As a reminder, our focus is on driving long-term relationships with our customers. We direct our stores to sell at MSRP. It helps to create the kind of sticky relationships that feeds our segment-leading aftersales performance. We realized it cost us some SG&A leverage in the short term. But for us, it's much more important to drive retention in the strongest part of our business which is aftersales.” –Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive“Our stores make those decisions in the field. And they do that based off their supply and what their competitors are doing. So yes, we do have some stores that are charging over MSRP. We don't have specific numbers because we don't specifically track it because we allow our network to make the decisions close as to what their customer base is and what the supply and demand is in that local market.” –Bryan DeBoer, President and CEO, Lithia MotorsConclusionAt 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.

February 2022 SAAR

The February SAAR was 14.1 million units, down 6.4% from last month and 11.7% below this time last year. After last month’s SAAR of 15.0 million, the 2022 Q1 SAAR is expected to be the highest since Q2 2021 when the vehicle inventory shortage started to fully take hold. While the seasonally adjusted annual rate has certainly improved from the lows of late 2021, raw sales numbers tell a different story. Raw sales volumes in February were much lower than in previous years, as shown in the chart below. Seasonal adjustments in the early months of the year typically account for lower expectations in those months after lofty sales expectations in December, explaining the discrepancy between raw sales and the SAAR metric. Unadjusted figures show just how constrained inventories are.Source: Bureau of Economic AnalysisIn February, the new vehicles that were available to sell continued to fly off the lot. According to J.D. Power, the average time a new vehicle sat on dealer’s lots was 20 days, down from 54 a year ago but up from the record low of 17 days in December 2021. In response to this persistently high demand, OEMs are expected to reduce incentive spending even more in February to a per unit average of $1,246. To give some perspective, when shown as a percentage of MSRP, incentive spending is at an all time low of just 2.8%. Average transaction prices on new vehicles are expected to reach $44,460 this month, an all-time February record and an increase of 18.5% from a year ago.Used vehicles continued to appreciate throughout February. While the intrinsic value of these vehicles might be unchanged or lower than months prior, constricted inventories continue to prop up price increases. According to J.D. Power, the average amount of trade-in equity that consumers were able to cash in on was up 93% compared to this time last year.Source: Bureau of Economic AnalysisComing as no surprise to dealers, new and used vehicle inventories remained scarce over the last month. The industry’s inventory to sales ratio was 0.171 in February, the lowest recorded value since the Bureau of Economic Analysis started tracking the metric in 1993. Inventory shortages have been present for almost a year now, and the supply chain issues that have perpetuated the shortage are here to stay until 2023 at the earliest. For more discussion on production issues, check out our January SAAR blog.Parts and Service Outlook – Manufacturers, Competitors, and TrendsAuto dealerships have several sources of revenue, including sales of new and used vehicles, financing revenue from internal F&I departments, and parts and service revenue from on-site vehicle repairs. While all of these revenue streams are essential to a successful dealership, the margin structures of each department fundamentally differ. Most important for this blog, parts and service departments have the healthiest margins at an auto dealership, making these departments essential to profitability.Higher fixed operations margins combined with increasingly aged vehicle populations have made parts and service departments more and more important over the last year and into the early months of 2022. Check out our recent blog for an in-depth look into the importance of fixed operations for your dealership. In this blog, we seek to provide an update on the auto parts industry, including manufacturers, competitors, and expected ramifications on dealers’ fixed operations.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs.Auto Parts Manufacturers – There are Always LosersLately, auto parts supply chains have been the target of headlines. While most of the discussions in our weekly blogs have focused on supply chain disruptions’ impact on the production of new vehicles, these same issues also apply to individual parts. Namely, auto parts manufacturers have been experiencing cost issues over the last year. They must feel like they are getting left out of one of the most profitable periods in the auto industry’s history.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs. This relief has not materialized due to the contract structure that the industry has in place, as explained in further detail below.Contractual agreements between OEMs and parts manufacturers set prices for the entire length of a vehicle’s production cycle and are difficult to renegotiate without both parties’ goals aligning. In the past, OEMs have not always benefitted from the fixed nature of these contracts and are now hesitant to renegotiate terms, especially when they are on the winning end of the deal. General Motors President, Mark Ruess, recently said that “passing things through is not the way to create value for customers.” While this may be true, the statement would also make sense if dealers and OEMs replaced customers.Auto Parts Retailers – Direct CompetitionAuto dealers are obligated to purchase parts for their service departments directly from OEMs. This relationship ensures that standardized replacement parts are offered to consumers and that OEMs can control the prices paid for these parts. In this framework, however, auto parts retailers like O’Reilly Auto Parts and AutoZone become direct competitors of auto dealers’ parts and service departments. The key question is: “Can these retailers get generic replacement parts cheaper than OEMs?” and “Can auto parts retailers effectively siphon off market share from parts and service departments?”Auto parts are getting pricier, and demand for those parts is increasing, but well below the rate of vehicle prices themselves. As shown in the chart below, motor vehicle parts and equipment were 12.6% more expensive in January compared to a year earlier, while used-car prices increased 40.5% in that same time frame. With consumer demand for parts and services high, auto parts retailers have been able to capture success. For example, in 2021, Advance Auto Parts increased its operating margin for the fourth consecutive year. Likewise, O’Reilly Auto Parts and AutoZone also experienced margin growth. As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie. When it comes to your dealership’s parts and service department, it is unlikely that future competition between auto parts retailers and parts and service departments reaches the point where significant market share is at stake. However, further margin improvement is expected across the board as high auto prices keep existing vehicles on the road for longer, requiring more replacement parts with favorable margins priced in.As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie.Trends – Expectations in 2022Like new and used vehicle departments, auto dealers’ parts and service departments are poised to thrive in 2022. Increased mileage on an aging vehicle population is expected to keep the demand for auto parts high and dealerships fixed operations are expected to remain strong enough to prevent lost market share to retailers. Increased automation, digitization, and electrification may represent a tailwind as professionals are more likely to handle increasingly difficult repairs. Also, margins should remain healthy as parts manufacturers struggle to enforce desired price increases.On the other hand, some factors could be a drag on parts and service departments’ success over the next year. For example, increased vehicle leasing could encourage consumers to put off repairs on cars and trucks that they do not personally own. More reliable models also tend to need less work overtime, as procedures like oil changes happen less often. Electric vehicles, a growing segment, raise issues for dealerships in the short and long term as dealerships are experiencing a shortage of qualified technicians and equipment to conduct repairs on these types of vehicles.March 2022 OutlookMercer Capital’s outlook for the March 2022 SAAR is pessimistic. January and February are the two months that require the largest seasonal adjustment to the SAAR metric, hiding low volumes behind low expectations that accompany any year’s first two months. Vehicle sales in March are typically higher than January and February, meaning that continued record low inventory and sales volumes are likely to rear their head in next month’s seasonally adjusted annual rate.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Price vs. Value

How Can the Conclusion of Value for the Same Auto Dealership Be Different?

Do you first see a man playing the saxophone or the face of a woman? How can different folks viewing the same image see different things? These types of images are fun and there are the reasons that we see what we see which involve human psychology and how the brain works. In terms of a business valuation, how can the conclusion of value for the same auto dealership be different?Arriving at Different Conclusions of ValueWe have heard it said that if you have ten different business appraisers perform a valuation of the same auto dealership, they might arrive at ten different conclusions of value. That doesn't sound comforting. How is this possible? In the previous two-part blog series on Levels of Value (here and here), we discussed a few potential reasons.Values can differ due to the appropriate level of value for the intended valuation or due to the purpose of the valuation. Values can also differ because the valuation process is both an art and a science. The science of valuation includes the three valuation approaches (asset, income, and market) as well as the valuation process (due diligence and financial modeling). The artful part of valuation incorporates all of the underlying assumptions including the appraiser’s understanding, interpretation, and support for each.Valuations can also differ depending on the Standard of Value used in the valuation. The three most common standards of value are fair market value, fair value, and strategic/investment value. A brief definition of each is as follows:Fair Market Value – The price exchanged between a willing buyer and a willing seller, both being informed of the relevant facts, and neither being under compulsion to buy or sell (generally includes the application of discounts for lack of control and marketability where applicable)Fair Value – Generally assumed to be fair market value without consideration of discounts for lack of control and marketabilityStrategic/Investment Value – The value to a particular investor or buyer based on their individual requirements and expectations. Because certain investors are able to generate higher returns from the same assets due to strategic opportunities, they can pay a higher price than other potential buyers and achieve the same level of returnThe Difference Between Value and PriceThe difference can also be explained by the difference between price and value. For a public company, these terms are supposed to be synonymous. In other words, the value of a share of Apple stock is equal to the market price of the equivalent share on a given day. Then again, if the price of every public stock was exactly what it was worth, would Warren Buffet be a billionaire?While the terms price and value are often used interchangeably, their meaning may not be synonymous in the context of a private business, or in this case an auto dealership. In this post, we examine the differences between price and value.The Price of an Asset or BusinessConversely, the price of an asset or business is governed by the supply and demand for that asset. As demand for an asset increases, the price will increase. As supply for an asset decreases, the price will increase. We are seeing the negative impact when both conditions exist in our daily lives with the prices of new and used automobiles, along with most consumer goods. This is also true for auto dealerships themselves. In an increasingly digital world, some of the large public auto retailers are acquiring dealerships in order to increase their scale. This added demand has boosted the Blue Sky values of dealerships. And while there are plenty of headlines about large deals and high valuations, the environment has persisted because strong earnings have made some dealers reticent to let go of their primary asset during a period of record performance.The price of a dealership may also be impacted by circumstances unique to the dealer principal. Selling the dealership may mean the loss of a salary in addition to the residual earnings of the dealership. Given the stage of life and other considerations, some dealers may not be willing to give up the golden goose, meaning it would take a much higher price to compensate them to exit the investment, perhaps exceeding the “value” of the dealership.Price, particularly in the stock market can also be affected by mood, momentum, and sometimes irrational forces. These factors are often referred to as Behavioral Economics. A classic example is “loss aversion” when a person refuses to sell a declining investment to avoid recognizing a loss. In such cases, the person is hoping for a recovery in the price before selling, even if their capital could be better deployed somewhere else. With the GameStop craze last year, plenty of investors piled into the stock wanting to be part of the crowd, being overconfident, or not properly assessing potential risk and return with the investment. While this undoubtedly plays a role in the elevated price, the vast majority of people buying acknowledged the stock price was not in line with the Company’s intrinsic value.The Value of an Asset or BusinessThe value of an auto dealership, or any asset, is generally based on its fundamentals. Under an asset approach, the value of an asset is typically based on the condition, age, and creator of that asset. For an auto dealership, the adjusted balance sheet indicates the fair market value of the tangible assets of the dealership. When combined with the Blue Sky value for the franchise rights, the resulting indication represents the total fair market value of the dealership. Under the income approach, the value of the business is determined by three primary factors: earnings/cash flow, risk, and growth. As cash flow/earnings or growth increases, the resulting value increases. As risk decreases, the resulting value will also increase all other things held constant.While a valuation considers the asset, income, and market approach, the difference between price and value might best be understood through the lens of these approaches. The asset approach is the price of all the Company’s assets, minus the price of its liabilities. The market approach is the price someone else might be willing to pay, based on prices paid for similar dealerships. The income approach however is more of a value perspective. It is based on an expectation of future earnings, weighed against a required rate of return. The value indication is primarily driven by these return expectations, rather than a price an investor would be willing or able to pay.Price or Value in Auto Dealership Valuations?After analyzing the differences between price and value, let’s revisit some of the purposes and data points for an auto dealership valuation to determine whether the conclusion represents price or value.Wealth Transfer/Gift and Estate – VALUEThe valuations of auto dealerships for these purposes are compliance-based and serve to protect the integrity of the transaction or transfer. The valuations are based on the classical valuation models and the conclusions will generally illustrate value.Valuation for Strategic Planning for Dealer to Contemplate a Sale – PRICEIn this instance, the appraiser might consider specific factors of the investment or buyer in addition to the classical valuation models. The conclusion might consider cost savings to the eventual buyer or improvements that a larger or more sophisticated buyer could implement to improve current operations.General Litigation or Divorce – VALUEIn the context of most ligation settings, the appraiser is asked to determine the value of the auto dealership for the trier of fact. Likewise, these valuations are based on classical valuation models and the conclusion will generally illustrate value.Internal Transactions within the Company’s Stock – VALUE and PRICEIn the course of a valuation of an auto dealership, the appraiser will ask management if any recent transactions have occurred in the stock of the Company. Transactions typically consist of an owner buying into the Company or the Company or owner redeeming another owner. These transactions can serve as data points to the valuation. Often, the sophistication and motivation of the buyer and seller are unknown. Further, many of these transactions occur without a formal valuation. In many cases, these transactions will reflect price (how much the buyer can afford to pay) and not necessarily value (what a hypothetical disinterested third party might be willing to pay). Typically, an appraiser would seek to investigate the motivation of the parties and evaluate the conclusion in the context of other classical valuation models to determine if they are an appropriate indication of value.ConclusionAs we have discussed, price and value are terms that are often used interchangeably. In the context of privately held auto dealerships, the terms can represent different conclusions of value. Some define price as what you pay for an asset, while value is what you receive or what something is worth.Understanding the purpose for a valuation and the appropriate level of value can dictate whether the conclusion represents price or value. Understanding these terms and the other factors discussed in this post can also explain some of the differences in concluded values for the same auto dealership.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.Last week's post and this week's post were adapted from a piece written for Mercer Capital’sFamily Business Director Blog.Part I of this two-part series described the Levels of Value and why the concept is so important to auto dealers. We present the Levels of Value chart below for reference. This week, we discuss four potential transactions in which selecting the appropriate level of value is critical and explain why: 1) estate planning, 2) corporate development, 3) divestitures, and 4) shareholder redemptions. Engagement administration and engagement planning are two steps in the valuation process that don’t garner much of the spotlight. However, defining the scope of the engagement is critical to the success of a valuation project. The scope and eventual engagement letter are often described as a road map for the project to follow. One of the great strengths of a family business is the ability to take the long view. Unburdened by the quarterly reporting cycles of publicly traded companies, family businesses can make investing and operating decisions for long-term benefit without worrying about the effect on the next quarter’s earnings. One of the foundations of this long-term perspective is the stability of ownership within the family. With an indefinite holding period, why does the value of the family business even matter? While the family may have an indefinite holding period, the fact of mortality means that individual shareholders do not. So, even for committed families, transactions will occur and valuations will matter. Let's consider four potential transactions in which selecting the appropriate level of value is critical.1. Estate PlanningMany family shareholders determine that transferring wealth to heirs while still living is advantageous. Regardless of the specific technique used, the value of shares in the family business is a cornerstone of the estate planning process. Under the IRS’ definition of fair market value, the appropriate level of value depends on the attributes of the block of shares being transferred. Since estate planning almost always involves transactions of minority interests in the family business, the nonmarketable minority interest level of value is relevant.There are also elements of estate planning that are unique to auto dealers. All dealerships must be operated by a Dealer Principal approved by the OEM. Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM. This approval is not always guaranteed. When desiring to transfer ownership to the next generation, dealers would be wise to consider a family choice that has been active in the dealership or has industry experience.Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM.Measuring the value of shares in the family business at the nonmarketable minority interest level of value is a two-step process. First, we consider what the shares would be worth if they were traded on an exchange (i.e., the marketable minority level of value). Second, we determine an appropriate discount to apply to that value to reflect the unfortunate side effects of owning a minority interest in a private company. The magnitude of that discount depends on factors like the expected duration of the holding period until a liquidity event, the level of interim distributions, and the expected pace of capital appreciation. When combined with an assessment of the risks facing the investor, these factors determine the marketability discount, which, in turn, defines the fair market value of the shares on a nonmarketable minority interest basis.2. Corporate DevelopmentFamily businesses have two basic pathways for growth: organic growth through capital expenditures (“build”) or non-organic growth through acquisitions (“buy”). The pathways are not mutually exclusive. Some families are culturally averse to acquisitions, while for others a disciplined acquisition strategy is part of the family’s business DNA. As we have discussed in this space in prior blogs, the prospects for organic growth for dealers are somewhat constrained. While dealers can improve Fixed Operations and Used Vehicle Operations, they are limited to selling more vehicles from their OEM on the new vehicle side of operations. Those growth opportunities have been more constrained over the last two years due to inventory shortages and the microchip crisis. For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For family business acquirers, developing an appropriate valuation of the target is essential. As one of our colleagues is fond of saying: “Bought right, half right.” Regardless of the strategic merits of a proposed acquisition, the overpayment will weigh on the returns available to future generations of the family. When formulating a bid price for a potential target, acquirers should seek to answer two questions.What is the business worth to the existing owners? Selling their business to you means that the existing owners will be giving up the future cash flows they expect the business to generate under their stewardship. This reflects the financial control level of value, which as we noted in last week’s post, is probably not much different from the marketable minority value.What is the business worth to us? To answer this question, acquirers need to carefully evaluate how the target “fits” with their existing business. Will the combination of the two businesses generate revenue synergies (i.e., 2 + 2 = 5)? Or are there duplicative costs that can be eliminated as a means of generating higher margins for the combined entity? Perhaps the combination will reduce the risk of the family business, or perhaps the family has access to lower-cost capital than the existing owners. In any event, family business acquirers should develop forecasts for the pro forma combined entity using well-supported inputs that reflect the strategic case for the acquisition to determine what the business is worth to them. Forecasts are less seldomly used in the valuation of auto dealerships, but the concept of determining the anticipated future earnings is the same. Auto dealers will generally evaluate the last two to four years of operations to arrive at that conclusion. Due to heightened profitability over the last two years, this exercise can be more difficult. We are seeing many dealers consider an average of several years of operations as an indicator of expected future operations. The difference between these two values defines the “space” over which negotiations will center. The ultimate purchase price will reflect the relative bargaining power of the two parties. As illustrated in Exhibit 1, bargaining power is a function of the number of likely buyers for the target, and whether the target represents a generic or unique opportunity for buyers.To avoid overpaying, savvy family business acquirers focus not just on what the target could be worth to them, but also what the target is worth to its current owners, along with a careful assessment of the factors that influence the relative bargaining power of the parties.3. DivestituresAt some point, many families transition to being enterprising families. In other words, they are defined by the fact that they pursue economic opportunities together, rather than by continued ownership of the legacy family business. In pursuit of broader portfolio management objectives, enterprising families may sell businesses from time to time. In this case, the dynamics described in the preceding section are reversed.In the auto dealer space, we generally see divestitures occurring for one of two reasons in recent times. First, smaller single-point dealers are facing more pressures to compete against larger auto groups in terms of online platforms, imaging requirements, and the fear/threat of electric vehicles being introduced into their models. Secondly, dealers that do not have an identified succession plan or successor Dealer Principal candidates are apt to consider selling. Heightened profits and heightened blue sky valuation multiples are also making the decision to sell more attractive in the current environment.As the seller, you won’t have direct access to what your business could be worth to the buyer. However, knowing how your industry is structured and how your business operates, you should be able to estimate potential revenue synergies and cost-saving opportunities available to the buyer.In order to achieve a sales price closer to the value of your business to the buyer, it is important to identify the attributes of your business that differentiate it from other potential acquisition targets available to buyers. Further, generating interest from a larger pool of buyers is essential to reaping greater proceeds from a divestiture.4. Shareholder RedemptionsA shareholder redemption is a purchase by the family business of shares from a family shareholder. As with our corporate development and divestiture examples from last week’s post, shareholder redemptions reflect an inherent tension between buyers and sellers, as illustrated in Exhibit 2. Unfortunately, we often see these events occur in litigation because of the differing perspectives described below. It’s common for dealers to incentivize key employees and management with an ownership stake as part of an employment agreement. These ownership interests become the subject of redemption if the employee resigns or is terminated from the dealership. In a shareholder redemption transaction, the buyer and seller do not share the same perspective.The selling shareholder owns an illiquid minority interest in a private business. As a result, the fair market value – the amount that a hypothetical willing buyer would pay – reflects a marketability discount. In other words, the nonmarketable minority level is relevant.However, in a shareholder redemption transaction, the buyer is not a hypothetical party, but the company that issued the shares in the first place. The family business is not burdened by the illiquidity of the shares in the same way a shareholder is. As a result, the value of the shares to the family business is consistent with the marketable minority level of value. It strikes us as a bit perverse to evaluate transactions between family shareholders and family businesses in terms of relative negotiating leverage. Instead, we prefer to frame the decision in terms of family business objectives: What is the purpose of the redemption? The “correct” price at which to conduct a shareholder redemption transaction is always a bit ambiguous. Consider the alternatives:Nonmarketable Minority Level. This seems straightforward – after all, that is the fair market value of what the shareholder owns. Why should the family business pay any more than that?Marketable Minority Level. On the other hand, this is the value of what the redeeming company is acquiring. Why should the departing shareholder accept any less than that? From an economic perspective, redemption at the nonmarketable minority level is accretive to the non-selling shareholders. Redeeming at the marketable minority level provides a windfall to the selling shareholder relative to the fair market value of their shares. There is no simple escape from this dilemma. The ambiguity around the level of value in these instances generally exists for engagements for internal and strategic planning purposes. If these events result in litigation, the levels of value are typically defined in the applicable standard of value or case laws of the jurisdiction governing the matter.If the family business wants to discourage redemption requests, the nonmarketable minority level of value may be preferable.If the family business is designing a shareholder liquidity program with a view to promoting positive shareholder engagement, it may be desirable to conduct redemptions at the marketable minority level of value. However, in such cases it is essential to set limits on the amount of redemption requests the family business will honor in a given period; otherwise, the liquidity program could trigger a “run on the bank,” crowding out corporate investments critical to the long-term sustainability of the family business.If the objective of the redemption is to “prune” the family tree of unwanted branches, it may be necessary to pay a redemption price at the marketable minority / financial control level of value. Depending on state statute, it may be a legal necessity. In any event, the departing shareholders are likely to demand such pricing to exit the family business.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Considering four common corporate transactions, we have illustrated why the level of value matters to family businesses:When transferring minority interests among family members in furtherance of estate planning objectives, the fair market value of the interests transferred is properly measured at the nonmarketable minority level.When considering a potential acquisition, family businesses should evaluate both the marketable minority / financial control level of value (what the target is worth to the existing owners) and the potential strategic control level of value (what the target is worth to the family business). These two values for the target define the relevant range for negotiating a transaction price.When divesting a business, the dynamics are reversed. The relevant negotiating range is set by the difference between the marketable minority / financial control level of value (in this case, what the business is worth to the family) and the strategic control level of value (what the business is potentially worth to the buyer). The family can improve its negotiating leverage in these situations by differentiating the business from other available targets and exposing the business to multiple motivated buyers.Finally, shareholder redemptions can occur at either the nonmarketable minority or marketable minority /financial control levels of value. The appropriate level for a given transaction should be selected with a view to the objectives of the redemption for the family business. These transactions can have profound and long-lasting economic implications for the family business and its shareholders. When the stakes are high, it’s a good idea to measure twice and cut once. When your dealership is preparing for any of these transactions, give one of our valuation professionals a call.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

In the spirit of Valentine’s Day, we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. In this week’s post, we adapt a piece written for Mercer Capital’sFamily Business Director Blog, and how it specifically relates to auto dealers. This will be the first part of a two-part blog series.Levels of Value OverviewShareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in Exhibit 1, there are three basic “levels” of value for a family business. Each of the basic levels of value corresponds to different perspectives on the value of the business. Let's explore the relevant characteristics of each level.Marketable Minority Level of ValueThe marketable minority value is a proxy for the value of your family business if its shares were publicly traded. In other words, if your family business joined the public ranks of Lithia, Sonic, Asbury, etc. through an IPO, what price would the shares trade at? To answer this question, we need to think about expectations for future cash flows and risk.The marketable minority value is a proxy for the value of your family business if its shares were publicly traded.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate. In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices. There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments. Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain. As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments. When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa. So, when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk. They will estimate this value in two different ways.When a business appraiser estimates the value of your business at the marketable minority level of value, they are focused on expected future cash flows and risk.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business. Many novice investors are aware of Price-to-Earnings ratios, and there are plenty of valuation multiples that can be gleaned from public auto dealers. While these are two distinct approaches, at the heart of each is an emphasis on the cash flow generating ability and risk of your family business. We start with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control). Acquirers are often classified as either financial or strategic.Financially motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1. Imagine a private equity buyer with no other auto dealership investments. They’ll pay for the right to earn the cash flows you’ve been generating, but other than some creative financing, they may not be able to meaningfully increase cash flows above what the current dealer principal can achieve.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded). For example, two adjacent auto dealers can likely run with a leaner management team.Strategic acquirers may be willing to pay a premium to the marketable minority value if they can achieve revenue synergies but, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value. However, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist. The name and branding may change, employees may be downsized, and production facilities may be closed. It also reduces a significant source of cash flow, as future earnings are accelerated to a lump sum payment up front. Many auto dealers have looked to exit with blue sky values high, but it’s also hard to walk away during a time of record profits in a business that can operate throughout the business cycle.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value. All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.The buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value.What factors are investors at the nonmarketable minority level of value most interested in? First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business. But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest? The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold. The longer an investor expects the holding period to be, the larger the discount to the marketable minority value. Imagine you own a 5% interest in a dealership that you’re looking to sell. If a potential buyer knows the dealer will “never sell to one of the big guys,” that will impact how much they’ll pay you for your interest.Expected capital appreciation. For most family businesses, there is an expectation that the value of the business will grow over time. Capital appreciation is ultimately a function of the investments made by the family business. Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return. Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares. All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value. Auto dealerships tend to have pretty strong cash flows, and relatively limited opportunities to reinvest in the business. While the OEM has imaging requirements every so often, the opportunity to meaningfully expand operations tends to be tied to adding on more rooftops.Interim distributions. Does your family business pay dividends? Interim distributions can be an important source of return during the expected holding period of uncertain duration. Interim distributions mitigate the marketability discount that would otherwise be applicable. High levels of distributions may be common for minority investors in auto dealerships. However, minority investors cannot compel these distributions themselves, and we’ve seen many cases where the cash simply builds on the balance sheet. As noted above, this can drag on returns.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above. As a result, they demand a premium return relative to the marketable minority level. The greater the perceived risk, the larger the marketability discount. A strong capacity for distributions and opportunities to be sold to a strategic buyer can push down marketability discounts for auto dealerships. Conversely, sporadic distributions and cash buildup can lower expected returns. And while dealerships must send monthly factory statements to the OEM, these don’t commonly get shared on a regular basis with minority investors who may not have a good pulse for how their dealerships are performing.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Hopefully, we’ve illustrated the “why” behind the various levels of value. In our next post, we’ll cover why getting the Level of Value correct is so important, and we’ll discuss numerous instances where a dealer may encounter the value of their store from different levels.

January 2022 SAAR

SAAR reached a seven month high in January, totaling 15.0 million units on an annualized basis. SAAR was up 20.0% from last month but down 10.4% from January 2021. While the SAAR certainly improved, raw sales volume in January was the lowest since April 2020. January is typically the lowest selling month for dealers each year, so the seasonally adjusted nature of the metric can make it difficult to compare with other months; it puts a lot of faith in the math required to annualize sales. The bar chart below shows raw sales numbers in January 2022 compared with raw numbers in January since 2015.Source: Bureau of Economic Analysis Unsurprisingly, many of the same trends that have dominated over the last year have persisted into early 2022. Auto manufacturers continue to prioritize retail deliveries over fleet deliveries. Sales continue to be held back by limited inventories. Light trucks continue to dominate, reaching 79.8% of all light vehicle sales over the last month. Within this popular category of vehicles, pickups and SUVs gained market share while the popular crossover segment’s market share remained flat from December. Vehicle sales prices and profitability remained high. After reaching an all-time high of $45,743 in December, the average transaction price of a new vehicle is expected to cool slightly to $44,905 while still notching an all-time January high.Due to these persistently high prices, trade-in equity also remains high for consumers, with average trade-in equity up 88% from this time last year. Incentive spending continues to fall. In January, average incentive spending per unit was $1,319, down from $1,598 last month and $2,163 a year ago, down more than 50%.Source: Bureau of Economic Analysis Reported beginning-of-month January inventory balances remained low but showed a marginal improvement from last month. Improvements aside, the industry’s inventory to sales ratio remained well below its long-run average of 2.45x, emphasizing the fact that supply chain and production recoveries still have a long way to go.Production Update – Stumbling Out of the Gate in 2022After inventory shortages constricted sales volumes throughout 2021, the biggest question for auto dealers and manufacturers going into 2022 has been “when is the production process going to recover?”. Optimists have been predicting that recovery would come in the second half of the new year, but marginal inventory decrements in November and December did not encourage those following the industry that a full recovery is likely in 2022. Over the last month, a couple of manufacturers have released production updates that emphasize the magnitude of these struggles, at least in the short run.January started off well, with no reports of any auto manufacturing plants experiencing problems in the early days after the holiday break. However, it didn’t take long before Ford reduced scheduled production at its Flat Rock, Michigan, Oakville, and Ontario plants due to chip shortages. Toyota Motor Corp. followed suit by cutting its worldwide February output forecast by 150,000 vehicles. In February, Toyota North America alone was reported to lose 25,000-35,000 vehicles to production cuts.Domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest.These types of announcements from manufacturers are not going away anytime soon, as domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest. While it seems the chip issue has been going on forever, we note it takes even longer to meaningfully increase chip production. Until that time comes, domestic manufacturers are going to have to continue to rely on international supplies of microchips, likely making for choppy conditions over the next year.The Biden administration announced its intention to take action on the current microchip shortage in October, releasing a statement:“As you know, we’ve been working on the semiconductor shortage since day one of the president’s administration and it’s time to get more aggressive. […] There are bottlenecks across the economy, mostly due to COVID. There’s a disruption in the supply chain. Some of it will work itself out naturally but others like semiconductors will require investments so we make chips in America again. We have to make investments now so that never happens again.”Furthermore, at a September convening of semiconductor industry participants, the Commerce Department announced the launch of a Request for Information (RFI) that asked all parts of the supply chain – producers, consumers, and intermediaries – to voluntarily share information about inventories, demand, and delivery dynamics. The results of this RFI, which included 150 companies across several industries, were released on January 25th.The Commerce Department concluded that "there is a significant, persistent mismatch in supply and demand for chips, and respondents did not see the problem going away in the next six months." The report also said that median inventory for consumers for key chips has fallen from 40 days in 2019 to less than 5 days in 2021. The hope is that this report will give legislators a more informed view as they consider taking action. For those that have lived through these daily struggles, the conclusions of this report are unsurprising, so hopefully, nobody was holding their breath.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022 and take some pressure off of existing facilities to meet the current level of demand. An uptick in supply would certainly be welcome and perhaps the latter half of 2022 will bring some inventory relief. In either case, LMC Automotive forecasts 86 million chips will be manufactured in 2022, an improvement of 6.2% from the 81 million estimated to have been produced in 2021. It remains to be seen how those will be allocated to vehicle manufacturing, but multiplying the anticipated increase in chip production by 2021 volumes, vehicle sales in 2020 would only be 15.8 million.Auto Forecast Solutions has aggregated vehicle production data following the chip shortage and its impact on auto manufacturing throughout the last month. The chart below shows the number of vehicles cut from production so far this year next to the full-year 2022 production cut projection: From an auto dealer’s perspective, not much has changed. Promises of structural changes to where microchips are produced and how many are available to auto manufacturers will take some time to follow through on, with the summer seeming like the absolute earliest that significant inventory relief might come. More updates should surface as the first quarter of the year is now in full swing.February 2022 OutlookOur outlook for February 2022 is that vehicle inventories will remain low and demand will remain high. Incremental inventory improvements are expected to accumulate eventually, but many of those improvements are not expected in the next several months. Also, the persistent Omicron variant of the COVID-19 pandemic could continue to affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Don’t Turn a Blind Eye to Fixed Operations

A Look at the Importance and Stability of Fixed Operations

The phrase, “don’t turn a blind eye,” refers to the idea that one should not ignore something they know to be real and significant. The phrase is said to originate from an 1801 English naval battle – the Siege of Copenhagen – where two admirals disagreed over battle plans. Legend has it that the second admiral in charge, Horatio Nelson, was ordered to withdraw but pretended not to see the flagship signals of the ranking admiral because he put his looking glass up to his eye that had been blinded in an earlier battle.As auto dealer headlines continue to be dominated by shortages of new and used inventory and record profitability, it’s easy to focus on the variable side of operations, including the sale of new and used vehicles. But, auto dealers and their trusted advisors should not turn a blind eye to the fixed operations of the dealership, which generally includes service, parts, and the body shop.While fixed operations may not be grabbing any of the current headlines, auto dealers should remain focused on their importance and stability to the overall success and profitability of a dealership. In this blog post, we analyze the recent historical contribution of fixed operations to overall dealership metrics, analyze several key indicators of future performance, and explore several myths and the changing landscape of the service department and customer relationship.Recent Historical Performance of Fixed OperationsLike all aspects and departments of an auto dealership, fixed operations or “fixed ops” have been impacted by COVID-19 and the initial lockdowns, plant shutdowns, chip shortages, and changing consumer behavior. Nonetheless, fixed operations have always provided a high margin portion of the business to an auto dealer while also connecting the customer to that particular dealership over the life of the existing vehicle and hopefully future vehicles to come.To gain a historical and current perspective on the impact of fixed operations on the total dealership operations, we have analyzed the Dealership Financial Profiles for an Average Dealership historically published by NADA. Specifically, we have analyzed year-end data from 2019 and 2020, along with the most recently published data from October 2021. This time period provides some insight into the impact and trends caused by the pandemic and indicates signs of recovery.In 2020, the average dealership had approximately $7.06 million in fixed ops sales, down 7.8% from the $7.65 million achieved in 2019. Through the first ten months of 2021, this figure was $6.41 million, which, if we annualize to twelve months, would be about $7.70 million, or just above 2019 levels. While this appears to be a full recovery, fixed operations pales compared to the performance dealers have achieved in variable operations as new and used vehicle sales, and margins have exploded despite/due to inventory shortages.As seen in the graph below, the gross profit margin on fixed operations has steadily improved, from 46.6% of fixed operations sales in 2019 to 47.0% in 2020 and 47.2% in the first ten months of 2021. Over this same time period, fixed operations sales as a percentage of average total dealership sales have steadily declined from 12.4% to 12.0% to 10.9%.Gross Profit Margin on Fixed OperationsSource: NADADespite modestly improving pricing power in fixed operations (orange line in the graph above), it appears to be declining modestly in importance to dealerships from a revenue standpoint (blue line). While fixed operations have always contributed less revenue to dealerships than variable operations (due to the high sticker price of vehicles), fixed operations have typically contributed a significant portion of total dealership gross profit. In 2019, fixed operations contributed 12.4% of sales but 50.5% of total dealership gross profit. This is because gross profit margins on new and used vehicles were 5.5% and 11.3%, respectively, compared to the previously noted 46.6% gross margin on fixed ops sales.In 2020 and 2021, this historical norm has been flipped on its head. In 2020, fixed operations only contributed 46.1% of total dealership gross profit. Through the first ten months of 2021, fixed ops contribution to total gross profit declined all the way to 36.5%.Fixed Ops Contribution to Total Gross ProfitSource:NADATwo of the primary causes of these trends are the huge increase in margins from variable operations and the lack of vehicle miles driven, which we have covered in a prior blog and will re-examine later in this blog. What may not be clear from these figures: fixed operations provide consistent, high margins to the dealership as evidenced by the departmental gross profit margin steadily, albeit modestly improving over this period. While it may not get all the headlines of variable operations, fixed operations continue to support dealerships and will continue to do so once vehicle margins normalize.Key Indicators of Future PerformanceVehicle miles traveled (“VMT”) is defined as the number of miles driven and has been tracked since 1971. The rolling 12-month average identifies the current run rate of this metric at any given point in time. An increase in VMT indicates more cars are on the road logging more miles, which eventually will require parts and service and eventually purchase a new vehicle either from new or used vehicle inventory. The rolling 12-month VMT drastically reduced at the start and during the early months of the pandemic due to temporary lockdowns and staying at home. In fact, the VMT dropped below 3.2 trillion miles in March 2020, and the rolling 12-month VMT declined every month before finally starting to rebound in March 2021.VMT has enjoyed a gradual monthly increase and returned above the 3.2 trillion figure for the first time in November 2021. It will be interesting to monitor whether the rolling 12-month VMT will continue to rise each month, just as it did pre-pandemic. The metric and the graph below indicate that consumers are traveling by car at rates not seen since before the pandemic.Moving 12-Month Total Vehicle Miles TraveledSource: FRED Economic Data A second metric that serves as a key indicator for the future performance of fixed operations is the average age of a car on the road in the United States. Like VMT, as the average age of a car increases, the need for service and eventually the purchase of a new vehicle alternative increases. According to IHS Markit and the Bureau of Transportation Statistics, the average age of cars on the road has generally increased from 1995 until 2021. Specifically, the average age of a car on the road has climbed from 8.4 years to 12.1 years.Average Age of Cars on the Road - U.S.Source: IHS Markit and Bureau of Transportation Statistics Coupled with the actual age, the average mileage of these cars is much higher than in prior years. While it wasn’t that uncommon for cars to have over 100,000 miles in years past, now many cars in service have 200,000 miles or greater. Based on a survey performed by iSeeCars, nearly 16% of Toyota Land Cruisers on the road have at least 200,000 miles on them.Fixed Operations Myths and Changing landscapeMyth 1: Auto Dealers make more money in Variable Operations than Fixed OperationsIn order to assess the validity of this statement, we must clarify a few parameters. Variable operations have always generated more gross or raw sales dollars than fixed operations for most dealers. The adage of making money usually centers around the profitability or margins provided by certain segments of the total auto dealership. Prior to the conditions of the last twelve months caused by inventory and chip shortages, fixed operations have provided a greater, or at least equal, contribution to total gross margin for a dealership as detailed earlier in the blog. Further, the specific gross margin on fixed operation sales has always been greater than the gross margins on new and used vehicles. While the transitory conditions have shifted more of the overall contribution of total gross margin to variable operations, fixed operations remain a vital, high-margin component of dealership operations.Myth 2: There is not much value in a service customer to my DealershipAs we just examined, the service customer is certainly valuable to a dealership if merely analyzed for the financial impact of their existing service requirements. In reality, fixed operations allow for ongoing touchpoints between a dealership and a customer. Touchpoints have been a common term used by executives of publicly-traded auto dealerships. Not only does that customer relationship have value during the life of the current vehicle, but the hope is that there will be future loyalty to that dealership in the decision to purchase the next vehicle. For these reasons, dealers should improve the overall customer experience, including efficiency and technology.2 out of every 3 service visits do not occur at a dealership.We have demonstrated both the financial and behavioral benefits of fixed operations to the dealership. Despite these gains, dealers have ample opportunities to improve the focus and market share of this element of the dealership. According to a 2021 survey conducted by Cox Automotive, only 34% of consumers prefer dealership service centers to general repair shops. While this figure represents a 1% gain in market share by auto dealers over the last three years of the survey, it still leaves 2 out of every 3 service visits that do not occur at a dealership. These overall figures mask the early years of a new vehicle's lifespan, where most service visits that fall underneath the warranty almost certainly occur at the dealership where the vehicle was purchased.The survey cites several reasons why consumers choose general service centers over dealership service departments: costs and location. Dealers must fight against the perception that dealership service costs are overpriced compared to similar services at a general service center. Additionally, consumers choose service centers closer to home than the original dealership. As we’ve discussed in prior posts, the future of the auto retailing landscape is changing. If fewer vehicles are kept on lots for the long-term, this may enable dealers to invest in real estate that is more proximate to consumers, which could increase market share for fixed operations.An additional component for the service department to monitor in the future will be the ability to service electric vehicles.An additional component for the service department to monitor in the future will be the ability to service electric vehicles (EVs). In last week’s blog, we discussed the future of auto dealerships and the impact of EVs on shaping the future of automotive retail. The Cox Automotive Survey cited that 66% of their current survey responders offer some level of EV service work. Additionally, 30% of responders plan to service EVs within the next year.ConclusionFixed operations have always provided stable, and high margin returns to an auto dealership's overall profitability and success. Particularly for single-point dealers with only one brand, dealers can see lagging sales if product offerings from the OEM don’t engage consumers, oftentimes for numerous years. However, fixed operations can get these dealers through the ebbs and flows of the business or product cycle.While recent trends have shifted the contribution and focus to variable operations, fixed operations continue to benefit dealers in the form of financial performance and bolster the customer relationship and loyalty to the dealership. Auto dealers must stay focused and adapt to these trends regarding their fixed operations despite persisting obstacles of consumer behavior and retail preferences. While 2022 may result in declining trends to the high wave of variable operations over the last twelve months, the future looks bright for the fixed operations of auto dealers. With fewer vehicles being put on the road than in years past, the average age of vehicles should increase and lead to more service work. Now it’s up to the dealers to pull in their share of these opportunities.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The Future of Auto Dealerships

How Inventory Shortages and Electric Vehicles May Shape the Future of Automotive Retail

Just as December is a good time to look back and reflect, January is a good time to look forward, to 2022 and beyond. When we value auto dealerships, we look back at performance in prior years because this helps to inform reasonable expectations for future performance. Prior to the pandemic, the directly preceding twelve months of performance may have been a reasonable proxy for ongoing expectations. However, throughout 2020 and 2021, discussions about when things will return to “normal” or whether we’re in the “new normal” have taken center stage.In order to look forward, we must also consider the past, or as Shakespeare’s Antonio would say, “What is past is prologue.” In this post, we look at two key trends in 2021 (inventory shortages and electric vehicles/direct selling) and how they may inform how automotive retailing will look in the future.Inventory ShortagesIn case you’ve been living under a rock (or working from home and refusing to turn on the news), new vehicle inventory has been tight, reducing availability and raising prices. While a lack of necessary microchips has stolen headlines, general supply chain issues are also at play (labor shortages, plant shutdowns due to COVID, etc.). From Econ 101, we know low supply leads to higher prices. And even though operating expenses have increased 16.3% for the average auto dealership in the U.S., pre-tax profits more than doubled in the first nine months of 2021.This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.For years, retail has been obsessed with discounts. Think 10% for signing up for a mailing list, free shipping for orders over $25, or straight to the point: Black Friday/Cyber Monday. Automotive retailing is no exception, with incentives reaching above $4,500 per vehicle prior to the pandemic. As discussed last week, incentives have plummeted in the low inventory environment. Unlike knick-knacks bought in the Christmas season, many car buyers don’t have a reasonable substitute. When their car breaks down, they need a vehicle and can’t wait months for inventory levels to normalize. This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.Auto dealers and their manufacturers are much more profitable under the current operating environment while producing fewer vehicles, reducing execution risk. It’s easy to chalk up these good times to temporary dislocations caused by COVID that will eventually normalize. But in a capitalist society, economic downturns tend to bring back the phrase attributed to Winston Churchill around World War II, “never let a good crisis go to waste.” OEMs will look at how they’ve adapted since March 2020 and look to keep profits higher with more efficient operations.Once the pandemic is finally in the rear view mirror, we think the level of inventories held on lots will be lower than pre-pandemic levels. While there is still a value to testing out the product before purchasing, we’ve seen other retail industries that hadn’t yet succumbed to ecommerce where certain buyers are now willing to buy sight unseen (see mattresses in a box). This shift in auto will reduce floor plan costs for dealers who can also downsize their real estate holdings or convert it to more service areas if they can find the technicians to fill the bays they already have. Smaller real estate requirements may enable dealerships to move to more cost-effective locations.But the main concern from dealers we’ve talked to is this: what if prevailing supply conditions fundamentally change the franchised dealer model?History of Dealer FranchisingTo understand the status quo of automotive retailing, we start at the beginning, when automotive manufacturer franchising of dealerships began in 1898. Back then, there were numerous methods of selling vehicles, including franchise locations, direct sales from factory-owned stores, traveling salesmen, wholesalers, retail department stores, and consignment arrangements. As automobiles proliferated, manufacturers preferred outsourcing sales to the franchise model, so they could focus on their core competency of manufacturing vehicles. They would rely on entrepreneurs to understand their local market in terms of which models were popular and where best to situate the dealership within the market. This also lowered investment for the manufacturers who could instead plow those resources back into product development.The franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.Once this investment was made by numerous “mom and pop” shops throughout the country, dealers lobbied to protect their investment. It was deemed unfair for the Big Three (Ford, GM, Chrysler) to be able to sell directly to consumers in lieu of through its dealers. Manufacturers already operate from a position of power as the sole provider of new vehicles to its franchisees, a risk known in valuation as “supplier concentration.” OEMs can unilaterally determine production levels, and according to a 1956 Senate Committee report, franchise agreements of the 1950s typically did not require the manufacturer to supply the dealer with any inventory and allowed the manufacturer to terminate the franchise relationship at will without any showing of cause. Manufacturers could overproduce and force dealerships to accept the cars with the threat of no inventory in the future. This occurred with Ford during the Depression. Thus, the franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.For perspective, restaurants don’t have similar franchise protections. For example, McDonald’s has both corporate owned and operated locations as well as franchise locations (approximately 93% of locations are franchisees). In this industry, there is heavy competition and franchisors often test out new products in their own locations before rolling them out to franchisees. This is quality assurance and also gives franchisors the ability to point to the success of a product so franchisees don’t feel like they’re being forced into something that may not appeal to their customers.While dealers made numerous lobbying efforts at the Federal level in the 1930s to 1950s, they made little headway. In fact, a 1939 Federal Trade Commission report found that manufacturers pitting dealers against each other actually led to an intense retail competition which ultimately benefitted consumers. To get the protections they sought, dealers turned to state legislatures, which is why franchise laws are largely handled at the state level. Today, all 50 states have laws that protect dealers, though the strength and terms of these laws varies by state. Common terms include the prohibition of forcing dealers to accept unwanted cars, protection against termination of franchise agreements, and restrictions on granting additional franchises in a dealer’s geographic market area. As many dealers today know, the OEMs still have significant bargaining power in these latter two areas.Direct SellingThe current market dynamic has prevailed for generations through numerous business cycles. Today, dealers are concerned that manufacturers may use electric vehicles (“EV”) as a means to skirt dealer franchise laws. Tesla has been very successful, particularly if you look at their share price, with its direct-to-consumer electric vehicle sales. OEMs naturally would like a piece of this (or anywhere near their valuation multiple).While Tesla has encountered legal troubles with its direct selling model, it’s important to note the difference between Tesla and other manufacturers. Tesla never pursued a franchise dealer model. Therefore, direct selling cannot disadvantage dealers of its vehicles since they don’t exist. Tesla offers a luxury product and has yet to reach a meaningful scale. Unlike OEMs of the early to mid-1900s, their product has not garnered mainstream demand, and they can therefore be competitive in their niche by keeping few parties in between the manufacturer and the consumer. While the below graphic is instructive, the OEM tends to play the role of plant, distributor, and wholesaler, meaning there’s really only one extra layer between manufacturer and consumer in this industry. Dealers naturally contend that direct-to-consumer EV sales should not be allowed as it could be a slippery slope to allowing the sale of all vehicles directly. There is nothing inherently different about the manufacturing and selling process as it relates to the powertrain of the vehicle. Tesla’s exception is not electric; it’s the lack of an existing dealer network. However, one of the benefits of the current dealership model is that consumers can return to the dealership to service their vehicle. If EVs deliver on their promise to require less maintenance than internal combustion engine (“ICE”) vehicles, maybe the need for this dealer network will be diminished in some regard. For now, electric vehicles are too expensive to be mainstream, but significant progress has been made on lithium batteries which have lowered costs. Still, massive investments in infrastructure will be necessary to make EVs practical. Electric vehicles are only 2.9% of the market, though combined with hybrids, alternative powertrains amount to 9.5%, with the remaining being internal combustion engines. While this is a relatively small piece of the market, it will likely grow over time.Source: NADA Market Beat December 2021ConclusionGiven the complexity of manufacturing automobiles and the heterogeneous preferences of consumers, we don’t think the recent shift to “just-in-time” delivery out of necessity will last. We believe electric vehicles will compose a much more meaningful market share, though we are less certain on the timing. While there are various proclamations of carbon-neutral by 2050 and the like, we think the market will determine when and how much electric vehicles hit the mainstream. If improved technology reduces costs and fears of range anxiety, EVs could be on the same playing field or even advantaged over ICE vehicles with higher upkeep costs (service and gas).We don’t believe electric vehicles will meaningfully change dealer franchise laws. However, we believe the trends we’ve seen of smaller stores being gobbled up by increasingly larger auto groups will continue, which is partially due to the threat of direct selling. However, smaller dealers are also getting out with valuations peaking, tax policy uncertainty, and increasing capital requirements to invest in digital platforms, automated systems, and the infrastructure to support electric vehicles rather than the direct selling of these vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Auto Industry Trends to Monitor in 2022

Less Is More?

With the start of NFL playoffs and our third accumulating snowfall in three weeks, we are once again reminded that the calendar has flipped over to a new year. No doubt if you watched any games from Super Wild Card weekend, you were also reminded that the auto manufacturers and beer producers are two industries that have become synonymous with advertising in the NFL. One such beer producer had a longtime advertising campaign where they debated whether their beer “tastes great” or is “less filling.” While consumers continue to weigh that debate, that same beer producer ended some of their commercials with the line “everything you always wanted in a beer. And less.”That slogan could easily have described the state of the auto industry in 2021. Some industry experts have referred to it as “less is more,” others as “the new abnormal.” There is no debate that the auto industry faced numerous challenges but was able to adapt and turn in one of its most profitable years on record in 2021.What trends can we expect to see in 2022 for the auto industry? What trends will we see “less” of? What trends will we see “more” of?In this blog post, we examine some of these trends and offer some predictions for industry conditions in 2022.Less: Incentives from the ManufacturerHistorically, OEMs have offered incentives to auto dealers on certain makes and models for stocking the companies’ products and promoting sales. As the supply of new units was diminished since the onset of the pandemic due to plant shutdowns and then ultimately a shortage in microchips, the demand to buy the limited number of units outweighed supplies and incentives have diminished for most makes and models. The following chart from JD Power/LMC Automotive displays the average incentive spending per unit and the percentage of incentives to the average Manufacturers’ Suggested Retail Price (MSRP) from December 2019 through December 2021. Specifically, average incentive spending per unit has declined by approximately $3,000 per unit from December 2019 to December 2021, representing a 65.3% decline. Incentives as a percentage of average MSRP has also declined from 11.0% to 3.5%. With continued inventory supply challenges expected to persist for most of 2022, expect OEM/Dealer incentives to continue to be lower than historical levels. Quite simply, the demand for inventory will outpace supply in the continuing months.More: SAAR/Total Retail Units SoldAs we reported in last week’s blog, the December SAAR totaled just 12.44 million units. The total number of units retailed for the year has been estimated at 14,926,900. Volumes were negatively impacted by the same conditions that impacted manufacturer incentives – plant shutdowns, chip shortages, and supply chain issues. Despite the success achieved by auto dealers over the past two years, the total number of retail units sold has lagged behind the prior five-year average. Many analysts that cover the industry would estimate that demand for the annual SAAR should hover around 17 million units. In fact, the average SAAR for the period from 2015 through 2019 averaged 17.24 million units. As seen in the graph below, the decline in sales for the last two years has created a deficit of approximately 5.08 million units. Some of this deficit may get offset or replaced by consumers that have either delayed their next purchase or shifted to purchasing a newer used vehicle rather than a new vehicle. With fewer vehicular miles driven, some of these retail volumes may be permanently “lost.” In any event, there is pent-up demand from consumers due to the inventory shortages over the last two years. The market will need to absorb this pent-up demand as more inventory becomes available. Several industry experts have weighed in on their SAAR estimates for 2022:Kevin Roberts – Car Gurus: 15-16 millionJonathan Smoke – Cox Automotive: 16 millionPatrick Manzi – NADA: 15.4 million SAAR will most certainly increase in 2022 out of necessity from demand from the prior two years. Full recovery to the 17 million unit historical levels will continue to be challenged by the inventory conditions from the OEMs. If the OEMs are able to produce more units in 2022, auto dealers will be able to increase the number of units sold from the prior two years.Less: Number of Models AvailableGiven the challenging industry conditions, OEMs have been forced to prioritize which models they produce. Most OEMs have had a difficult time producing their full lineup of vehicles. Specifically, two segments that are among the hardest hit are the luxury market and cars (as opposed to crossovers and pickup trucks). In normal production years, luxury cars are more limited in supply than other brands, but those are being more impacted in 2021 and are being the hardest hit with seller markups. Cars and sedans are also seeing a reduction in the number of units produced. Consumer behavior, in addition to inventory shortages, is to blame for this phenomenon. According to a recent article in Newsweek, trucks and SUVs compromise nearly 81% of the total vehicles manufactured.OEMs will continue to prioritize the production of models based upon:units dealers are selling the most frequentlyunits for which necessary parts and microchips are availableunits achieving the highest margins. Like many industry experts, we anticipate the number of models from each OEM will continue to be limited in 2022.Less: Features on VehiclesAs we all learned in 2021, many of the accessories and features on our vehicles are powered through microchips. The microchip shortage has caused production delays and shortages. Some analysts have estimated that the global microchip shortage has cost the auto industry millions of lost vehicles and billions in lost revenue in 2021. How long are conditions expected to persist?Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced.Most auto manufacturer plants can operate two production shifts five days a week or a total of 10 shifts per week. In times of high production needs, auto manufacturers can increase the total number of shifts to 21 shifts per week. In contrast, semiconductor plants are expensive, slow to build, and more complex to operate. For example, most microchip plants operate 24 hours per day, 365 days per year, so there is no room to increase production in existing plants to make up for any shortfalls. Further, the life cycle of a microchip plant from breaking ground on the facility to the start of production can take up to five years, compared to the six-month lead time at an auto manufacturing plant. Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced, packaged, and shipped to an OEM for installation on a vehicle.So while companies such as Taiwan Semiconductor Manufacturing Company (TSMC) and others are making the investment to build new chip factories, it’s going to take considerable time to meet current demands. TSMC began building a new factory in Arizona in June, and Samsung is planning a new chip plant in Texas.Given supply constraints, OEMs can either produce fewer vehicles with the same number of features, the same number of vehicles with fewer features, or a combination of the two (smaller reduction of both vehicle volumes and features). As we saw in 2021 and anticipate into 2022, the auto industry will continue to suffer from the microchip shortage. Consumers will see the impact materialize in fewer accessories and features on the new vehicles produced in 2022.Less: Number of Electric Vehicles (EVs) on the MarketIn last week’s blog, we also commented on the OEMs participation and activity in the electric pickup truck race. The activity isn’t just limited to Ford, Chevrolet, and Tesla as newer manufacturers such as Lordstown Motors, Bollinger, and Atlis Motors are also entering the market.The demand for battery-electric vehicles doubled during the first half of 2021.While EVs only account for a fraction of the new vehicle sales in the United States, the demand for battery-electric vehicles doubled during the first half of 2021. Just last week, representatives from NADA, General Motors, and the United Auto Workers testified in a House hearing on the impact of EVs on rural communities. Many dealers indicate the desire and energy to participate in the direct sale of EVs once they are rolled out from production from the OEMs. Auto dealers wish for traditional state franchise laws to be upheld that govern the licensing and regulation of distribution and the sale and service of EVs. Specifically, auto dealers in rural or non-metropolitan areas want to make sure they are not excluded from participation due to a lack of technological innovations. Similar to other advancements such as electrification, broadband, and telephone service, rural area auto dealers want to ensure that they will be given the same priority and attention as their urban dealer counterparts.Consumer behavior and preference may also play a key role in the increased number of EVs on the road. According to a 2022 State of the American Driver Report from Jerry, 47% of millennials are interested in buying an EV as their next vehicle. Gen Z and Gen X also show strong interest in EVs at 41% and 38%, respectively.ConclusionAt 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 and litigation support 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.

December 2021 SAAR

The December SAAR totaled just 12.44 million units, down 3.5% from last month and 23.7% from December 2020. Inventory shortages, supply chain issues, and consistently high demand have been commonplace in the auto industry since the summer. That being the case, December’s low SAAR should not surprise many.Several trends that have been observed in the industry over the last six months have continued to persist. For example, dealers continued to sell out inventories. According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days, beating last month’s record of 19 days and even further down from 49 days a year ago.Transaction prices continued to climb over the last month as well. The average transaction price reached its own record of $45,743 in December, up from $44,000 last month and the metric’s first time above $45,000. Light trucks continue to dominate sales, accounting for 77.6% of all new light vehicle sales in 2021. This vehicle class includes crossovers, which accounted for 44.9% of all new light vehicle sales over the past year. Dealer incentives also remained low, falling to just $1,598 of incentive spending per vehicle, an all-time December low. All told, this past month was more of the same for auto dealers and manufacturers.According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days.December inventory levels remained low. As a result, the industry’s inventory to sales ratio took another step down from 0.39 in October to 0.24 in November. There should be some incremental gains in inventory levels throughout 2022, but the exact point at which the supply chain tide will turn is still unknown. As far as auto sales are concerned, the pace remained red hot. High consumer demand for vehicles continued to empty lots around the country in December. In fact, in spite of the last six month’s conditions, 2021 new light sales totaled 14.93 million units, up 3.1% from 2020’s 14.47 million. When looking back at the past year in auto, it seems likely that 2021 sales of new light vehicles could have easily climbed to 17 million units in an unrestricted environment given the strong demand.Electric Pickup Truck Race Heats UpThe long-fought war between auto manufacturer’s pickup trucks has finally been pushed into the electric vehicle spotlight. As many manufacturers unveil their spin on an electric pickup, there are many questions that dealers and consumers have about brand loyalty and availability for these types of vehicles. The definitive answers to those questions won’t come for some time, but the conversation among consumers and those covering the industry has certainly started to heat up.Many major auto manufacturers have already announced plans to roll out electric pickup models. In December, General Motors released a video teasing an electric version of its GMC Sierra. This came one day after Toyota revealed its plans for an electric pickup in its near future. Nissan Motor Company showed off an electric pickup prototype in November called the Surf-Out, and newly publicly minted automaker Rivian, is taking preorders on its R1T and R1S electric truck and SUV.Ford announced that it has logged about 200,000 non-binding reservations for its F-150 Lightning, a battery powered truck that goes on sale this spring. The automaker has also announced its investment in a West Tennessee F-150 Lightning facility. Tesla announced its Cyber Truck in late 2019 but has recently removed information about production timelines from its website, implying a slower start to its electric pickup rollout than expected but perhaps still ahead of its competitors. There are several other manufacturers seeking to enter the market, including Lordstown Motors, Bollinger, and Atlis Motors.Moving on from the manufacturers and onto their customers, brand loyalty has always been more tangible in the market for pickup trucks than for any other class of vehicle. In years past, convincing a [insert name here] truck enthusiast to switch to another brand would have been harder than pulling teeth. However, the age of pickup loyalty may be on its way out due to high and rising sticker prices.A survey in 2019 conducted by used-vehicle shopping site CarGurus, found rising price sensitivity among truck owners, with more than two-thirds of respondents calling today’s pickups overpriced. We note price sensitivity is more likely to be apparent in used vehicle buyers, but brand loyalty was also found to be surprisingly fluid, with more than a third of Ford and Chevy buyers saying that they would consider the rival brand for their next pickup purchase. While these results may be true for gas powered pickups exclusively, the presence of deteriorating pickup loyalty makes for a blurry entrance into the electric market for dealers and manufacturers alike.The age of pickup loyalty may be on its way out due to high and rising sticker prices.With all these new models on the horizon, auto makers are hoping to gain an edge in a key battleground for the industry. Pickups are among the industry’s most profitable units, especially for U.S. automakers like GM and Ford where they account for a large share of global profit. If consumers embrace the shift to electric trucks, the segment’s early performance should inform dealers on how to respond and what works best on their lots. It will be interesting to see how OEMs are able to meaningfully scale production of these EVs in 2022 in light of tight inventories.January 2022 OutlookOur outlook for the first month of 2022 shows vehicle inventories remain low, and demand remains high. Incremental inventory improvements are expected to accumulate throughout the year, but many of those improvements are not expected in the next several months. Also, the persistent COVID-19 pandemic could further affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

2021: The Year of the Used Car

What Does This Mean for Dealers and Consumers?

2021 was an interesting year for many businesses, and it was certainly interesting for auto dealers. While automotive retailing may be an attractive space for purely financial investors, many dealerships are owned by the same folks that run the business. So while inventory shortages and other headwinds played a role in heightened profits in 2021, the return on investment achieved came with many operational headaches.Just about everyone we’ve talked to acknowledges that current performance is not indicative of ongoing expectations. The question has largely been focused on when we’ll revert to the mean, but this post touches on what things will look like when we return to a more “normal” operating environment. Specifically, what negative equity from used car buyers in 2021 may mean for dealerships.Used Car PricesIn a recent whitepaper, KPMG warned that used vehicle prices could fall abruptly and raise negative equity issues once new vehicle supply rebounds. Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth. We’ve all heard about a vehicle losing value once you drive it off the lot and it's true. Compounding this problem is the expectation that values today will materially decline in a year or two which increases the likelihood of negative equity.Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth.In April 2020, during the depths of the pandemic, 44% of trade-ins carried negative equity – more than double the amount seen a decade earlier. The average negative equity then was $5,571. A year later, vehicle prices increased significantly, but average negative equity only declined by a little more than $1,000. More importantly, the proportion of trade-ins with negative equity was relatively constant, meaning nearly half of buyers were looking at their trade-ins adding to the price of the vehicle they were looking to buy.According to our analysis of NADA data from 2011 to 2020, used vehicle retail prices increased at a compound annual rate of 2.7%, just above the 2.6% increase for new vehicles. In 2021, used vehicle prices lurched forward faster than new vehicles. New vehicle prices increased 7.5% in the last twelve months due in part to supply shortages. Consumers who couldn’t get the new vehicle they wanted or realized they needed a car, but prices were too high, may have turned to used vehicles, whose prices increased 19.1% due to increased demand.The ratio of used-to-new vehicle prices was 62.5% through October 2021, notably higher than the 56.5% observed in October 2020 and above the long-term average (2011 to 2020) of 57.1%. Used-to-new retail volumes were also 91.9% for the first ten months of 2021, higher than any full-year since at least 2011. Used vehicles have become increasingly important to dealers, as this figure has steadily increased from a recent low of 73.9% in 2015.What will happen if new vehicle supply is restored and used vehicle prices crater?As KPMG warns, what will happen if new vehicle supply is restored and used vehicle prices crater? Applying the long-term average used vehicle price appreciation of 2.7% to the $22,027 average used vehicle retail price in 2020, it would take until 2027 to reach $26,000. As of October 2021, the average retailed used vehicles cost $25,904. If used car prices revert to the long-term relationship of new car pricing (57.1% of $41,421 for new vehicles as of October ‘21), we would see a decline of 8.7%. KPMG indicated “a 20-30% plunge in used vehicles costs is within the playing cards.” This would almost certainly wipe out any consumer's equity who elected to finance their purchase.Consumers are able to buy more expensive cars when they get what they perceive to be a good deal on their trade-in, and higher used vehicle prices mean trade-ins are more valuable. However, this important source of cash for buyers will evaporate if used vehicle prices plunge, and negative equity just adds on to the price of a vehicle, putting pressure on how much consumers can pay up for a new vehicle. As noted previously, through April 2021, a significant number of buyers still had negative equity despite advantageous pricing on used vehicles. This could spike if prices crater.What It Means For DealersGiven the long life cycles of vehicles, dealership performance tends to ebb and flow with the economy. Executives of public retailers harp on the importance of touchpoints with the consumer, meaning they return to the dealership to get their car serviced. Dealers also hope customers return to their showrooms when it’s time for another vehicle, and the experience from the last purchase will likely play a big role.If consumers are unsatisfied with their purchase because prices were elevated when they bought in 2021 and decline significantly thereafter, they may feel aggrieved and choose to go with another dealership. While this situation is largely unavoidable for most dealerships, it could have negative ramifications down the line. Consumers may also choose to hold onto their vehicles longer to not recognize the loss by trading in. While it’s unclear how this will shake out down the road, dealers will need to prepare themselves for difficult conversations.Through the first ten months of 2021, the average dealership has already made nearly $3.4 million.As we alluded to previously, profits are up for dealerships in 2021. According to the NADA, the average dealership earned average pre-tax profits of $1.4 million from 2011 to 2020. Average pre-tax profits reached above $2.1 million in 2020, which was the first time above $1.5 million since 2015. Through the first ten months of 2021, the average dealership has already made nearly $3.4 million with two more months to add to these totals.The value of auto dealerships is communicated through Blue Sky values, which are based on a multiple of pre-tax earnings. While dealers aren’t likely to get a high multiple on peak earnings, we note both Blue Sky values and multiples are up since before the pandemic. However, once performance normalizes, dealerships may not be worth as much as they are now, much like the vehicles they sell. This would likely explain the record amount of M&A activity seen in 2021 with some of the largest dealer groups opting to sell.According to the Q3 2021 Haig Report, the average franchise has a Blue Sky multiple of 5.24x and adjusted pre-tax earnings of $2.08 million for a Blue Sky value of about $10.9 million, up 61% from year-end 2019 to all-time highs. At these prices, buyers must be optimistic that the good times will continue, multiples won’t crater, and/or the new normal of profits will be higher than historical levels.Source: Haig Partners Haig’s estimated pre-tax earnings of $2.08 million as an ongoing figure today is about 46% below current levels based on our calculations of NADA figures. However, according to NADA, it coincidentally represents a 46% increase over the 2011-2020 average for the average dealership. While that makes the ongoing figure appear reasonable, the chip shortage universally viewed as a temporary problem is far from “normal.” Suppose current estimates of ongoing earnings end up being overly optimistic, with an increased focus on recent outperformance. In that case, the values of dealerships, like the vehicles they sell, are likely to decline.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

November 2021 SAAR

The November 2021 SAAR was 12.9 million units, down 0.7% from October and 19% from November 2020. This month’s SAAR came in below expectations as the industry experienced only slight inventory improvement from the historic lows of September and October. This seems like old news, as persistently limited inventory on dealer lots has affected the industry for months now and has been the principal issue concerning auto dealers. In this environment, vehicle prices remain elevated, with the average transaction price paid for a new vehicle reaching a November record of $44,000 this month. Light trucks continue to be red hot, representing more than 80% of all new vehicles sold and leaving dealer lots at a record pace. The average number of days a vehicle stays on the lot fell to a record low of 19 days in November, down from 48 days in November 2020. It is no secret that inventory issues at the dealer level are a consequence of production stoppages and supply shortages by OEMs. OEMs have all been subject to supply chain disruptions for some time, and these challenges have been met with a wide range of responses. Jeff Schuster, president of J.D Power’s Americas operations and global forecasts recently addressed these responses by saying: “The supply shortage is being managed in very creative ways, from building vehicles without certain content, to bringing chip development and production in-house for better supply chain visibility. However, the improvements in vehicle production are inconsistent around the world. China and India both saw stronger vehicle production in October, but North America and Europe remain constrained. Even as plants restart after being down for several weeks, they are not running near-normal levels. While the solutions are intended to minimize the disruption now or in the future, consumers will continue to find it difficult to purchase the exact vehicle they want for several months to come."At least partially as a result of these “inconsistent” conditions across countries, the market shares of certain manufacturers have fluctuated a bit over the last month. Toyota, Hyundai-Kia, Honda, Nissan, and Mazda are among the manufacturers that experienced market share growth in November, while American manufacturers Ford, Stellantis, and General Motors all saw market share losses. This trend in auto public equities has been around for a few months now, but it shouldn’t take long for American and European manufacturers to catch up with their counterparts in other parts of the world by establishing in-house microchip development and securing a consistent pace of production going forward.What Could 2021 Mean to the Industry’s Future?For the last SAAR blog of 2021, we thought it might be valuable to reflect on the unique year that auto dealers and manufacturers have had. This is not a comprehensive recap of a year, but instead a commentary on what seemed to work well in 2021 and what changes might be around for a while.2021 defied nearly everyone’s expectations.While 2020 presented its own set of challenges and opportunities, 2021 defied nearly everyone’s expectations. Analysts following the industry watched as OEMs and dealers reacted to unprecedented conditions in almost every phase of their businesses. We saw dealer principals shepherd their auto dealerships through a choppy market environment and thrive in the current pricing and inventory environments. As the second half of the year wound down, new records were being set every month relating to low stocks of vehicles, elevated, and persistently rising gross profits, and consumer demand for autos of all classes. We also saw a red hot M&A market, with elevated Blue Sky multiples and record-high earnings driving mass amounts of industry consolidation by the public auto dealers like Asbury, AutoNation, Group 1, and Sonic Automotive.The motivation behind a chunk of the sales volume in 2021 seems unique to the times.On the other side of vehicle-buying transactions, vehicle scarcity and inflated sticker prices have left many consumers feeling uncertain about the future of car-buying and when they may choose to make that big purchase. Prospective buyers on the margins may have decided to hold off on buying their next vehicle in the hopes that prices will fall as inventory levels normalize. Others have chosen to take the opportunity to cash in on high trade-in values for their used vehicles that won’t stick around for long. In either case, the motivation behind a chunk of the sales volume in 2021 seems unique to the times we are living through. Many consumers are under the assumption that when things “get back to normal” the car-buying experience will closely resemble what it was pre-pandemic. While that will surely be true for many aspects of the sales process, auto dealers and manufacturers would be remiss not to take the lessons learned in 2021 and make some of the changes permanent in how they do business going forward.We aren’t likely to see high margins on vehicle sales persist.Could pre-orders on many models become more commonplace as dealers find the perfect inventory balance on their lots? Absolutely. Could record low dealer incentives persist in an effort to assist dealers in competitively pricing their vehicles when sticker prices inevitably fall off? Perhaps. But for changes like these to stick, factors like test drive availability and matching model-specific production volumes with the pent-up demand that exists will have to be addressed. It is also important to note that many local, full-service dealerships seek to gain loyalty through providing as great a personal experience for the buyer as possible. Repeat customers and parts and service revenues are very important to these dealers, and making customers feel like they are getting gouged is not in anyone’s best interest. For that reason, we aren’t likely to see high margins on vehicle sales persist. However, dealers and OEMs certainly learned there’s been money left on the table in the past due to the relative inelasticity of demand for vehicles.ForecastWhile December is typically a big selling month for dealers, we don’t see much changing the supply issues in the next couple of weeks to close out 2021. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

Q3 2021 Earnings Calls

Third quarter earnings calls across the group of public auto dealers began with similar themes from the prior two quarters: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit or revenues.Supply chain disruptions caused by the microchip shortages continue to impact inventory levels on new and used vehicles for all auto dealers. The public auto dealers are not immune from these conditions as well. Average days’ supply for new and used vehicles for the six public auto dealers as of September 30 are as follows: We have focused previous blogs on the conditions impacting new and used vehicles and their contribution to overall profitability. While those themes still existed for the Q3 earnings calls, we will focus on other areas of profitability for the public auto dealers, including Fixed Operations and Finance and Insurance (F&I). Additionally, the M&A market for the entire industry continues to accumulate transaction volumes at record levels. While much has been discussed regarding the pricing of those transactions in terms of multiples paid and which historical earnings to consider for ongoing performance, we will discuss some of the other factors public executives consider when making acquisitions. Will inflation be the next disruptive force to impact the auto dealer industry as we close out 2021 and head into 2022? Find out how public executives view inflation to the auto consumer and how that might affect new and used vehicle transactions. Finally, we will examine some of the themes and performance enhancements that public auto dealers continue to experience from the digital and omnichannel platforms outside the obvious digital transactions of new and used vehicles. Theme 1: Public auto dealers report improvements in Fixed Operations and Service stemming from recovery in vehicle miles driven post-pandemic. Customer pay has continued to improve while collision work has lagged. “Consumers are approving more work than they had in years past, and they’re spending more dollars per order […] We do see more opportunity to be more digital and be more engaged and transparent with the consumer […] and mainly our source is text messaging. We’re communicating through text message.” – David Hult, President & CEO, Asbury Automotive Group“The strong areas, obviously being areas of customer pay have continued to perform well versus both 2020 and 2019. The one area that continues to be a little bit of a laggard is collision, we do anticipate as miles continue to improve that will fully recover.” – Joe Lower, Chief Financial Officer, AutoNation“Our customer pay continues to ramp -up following a very strong first half of the year with 19% same-store dealership gross profit growth compared to the third quarter of 2019 […] despite continued headwinds in warranty and collision, both of which we believe will reverse in time.” – Daryl Kenningham, President U.S. and Brazilian Operations, Group 1 Automotive“Our service and parts […] it’s a huge tailwind for us. Our warranty was only off 9% […] our customer pay was up 21%” – Jeff Dyke, President, Sonic AutomotiveTheme 2: Public executives report strong results in the F&I department fueled by escalating transaction prices and low-interest rates. The lower volume of new vehicle units retailed is also affecting the mix of F&I revenue as penetration from product sales is outpacing warranty and reserve components.“Our strong, consistent and sustainable growth in F&I delivered an increase of $155 to $1,955 per vehicle retail from the prior quarter […] We like the fact that 70% of our F&I number is product sales and only 30% is reserve […] [regarding our recent acquisition] Larry Miller group has better penetration numbers than we do. So we’re certainly excited to learn from them and grow as well.” – Dana Clara, SVP of Operations, and David Hult, President & CEO, Asbury Automotive Group“The real driver for us [on F&I] has been increased penetration […] about two-thirds of F&I for us comes out of product versus financing.” – Joe Lower, Chief Financial Officer, AutoNation “22% increase in F&I income […] The adjacency that we are furthest along with is Driveway Finance or DFC […] Driveway Finance earns three times the amount earned than when we arrange financing with a third-party lender […] Driveway Finance can penetrate 20% of our financed retail sales.” – Bryan DeBoer, President & Chief Executive Officer, Lithia MotorsTheme 3: Supply chain disruptions have affected all industries including the auto dealer industry. Executives are watching how inflation and rising interest rates might impact the purchase of new or used vehicles in the coming months.“We’re watching inflation and the CPI […] what they’ve missed is the consumers are very happy with that pre-owned valuation that they own, that the 275 million vehicles on the road in America are worth more. That has made the consumer happy, not unhappy […] so once you see the other side of the coin, that consumers are not unhappy with this, they don’t consider it inflation [….] [consumers say] oh I made a pretty good investment […] it’s worth more. And if I want to sell it, I can get a nice check. And if I want to trade it, I have a reasonable difference. As soon as you realize that the consumer doesn’t view that as inflation, but as a win for them, then you understand our optimism and our confidence about the future of automotive.” – Mike Jackson,Chief Executive Officer, AutoNation“I don’t think there’s any doubt that inflation is a business factor […] I don’t think we can call it transitory or anything like that […] the costs are going to go up on everything, but the affordability of vehicles is more dictated by retail financing and leasing. And with high used car values, and low interest rates, I don’t see this inflation raining on the vehicle sales parade in the foreseeable future." – Earl Hesterberg, Chief Executive Officer, Group 1 AutomotiveTheme 4: M&A continues to dominate headlines. 2021 will see more transactions than any year in recent history. “I think fragmentation provides an opportunity for consolidation. With the investment required today, I think there’s a number of smaller dealerships that will become available. I think the deals that we see, the bigger deals are expensive. And many of them require CapEx and also then would provide some input from the standpoint of framework agreements with the manufacturers.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“So we visited all of the RFJ stores […] the entire management team is coming along for the ride […] we kind of walk into one of their stores and if feels like a Sonic store, they run their playbooks very similar to us. […] They are a fantastic leadership team. […] This is a perfect fit for us.” – Jeff Dyke, President, Sonic Automotive“[Regarding the Greeley Subaru, Kahlo CDJR, and Arapahoe Hyundai announced transactions] The brand mix is about 50% luxury and then mostly, import with one domestic store as well. It’s a really a very strong group with the right brand mix in a market that we’ve been trying to grow.” – David Hult, President & Chief Executive Officer, Asbury Automotive GroupTheme 5: Digital/omnichannel advancements are happening to meet consumer demands and enhance the retail experience. Improvements consisted of more than just unique digital visitors and increased online transactions. Improvements include average deal time, used vehicle procurement, headcount efficiency, and the ability to serve consumers with all credit scores.“I think the reason you are seeing higher credit scores and higher down payments on the tool [Clicklane] is it’s simplistically someone with a 750-Beacon score understands that they’re not worried about financing and understands that they can get what they want […] [we] certainly see [sic] lower credit scores as well on there […] there’s a broad mix, but again, the score average is certainly higher.” – David Hult, President & Chief Executive Officer, Asbury Automotive Group“We’ve demonstrated that we can operate the business at a lower relative cost than was done historically in large part by the deployment of digital tools that are making our sales and service associates far more effective […] we’ve been able to continue to operate with 3,000 plus fewer heads within the store environment on a same-store basis year-over-year.” – Joe Lower, Chief Financial Officer, AutoNation“We’ve increased the productivity of our salespeople by 30%, pre-Covid versus today […] selling 13 or more units a month instead of 10 […] nearly 40% of our customers are scheduling appointments online these days” – Earl Hesterberg, Chief Executive Officer, and Daryl Kenningham, President of U.S. and Brazilian Operations, Group 1 Automotive“The average Driveway consumer is averaging exactly 50 points lower on their FICO scores. So there are 671 versus 721 in Lithia […] We did finance a higher percentage of customers in Driveway at 75% and only financed 67% of Lithia customers.” – Bryan DeBoer, President & Chief Executive Officer, Lithia Motors“Omni-channel is just not selling vehicles. You think about service appointments, online payments – that is key.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“EchoPark is all about buy the car, transport the car, recon the car, merchandise the car and moving like 12 days to getting on the frontline, it’s gone […] EchoPark model is a one-to-five year old model under 60,000 miles” – Jeff Dyke, President, Sonic AutomotiveConclusionAt 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 and litigation support 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.

EV Start-Up Rivian IPOs at Valuation of $86 Billion

What It Means for Ford, Other OEMs, and Auto Dealers

The stock market is near record highs despite the global economy still working on climbing out of a once-in-a-century pandemic. A couple of themes for high-flying equities are ESG and companies that have yet to turn a profit. Rivian Automotive takes this a step further, as its prospectus indicates it will lose $1.28 billion in the third quarter while revenue will range from $0 to $1 million. However, as of its opening price, Rivian is already worth more than Ford and GM. From a valuation perspective, all the value is clearly placed in the terminal value with minimal production to date.Amazon and Ford are backing the electric vehicle startup, and investors are clearly betting the company can grab a meaningful amount of the burgeoning EV market. Rivian has beat Tesla, GM, and Ford to market with a fully electric pickup truck, the R1T. While this is expected to launch in December, it remains to be seen how meaningfully the company can scale production—if it can’t, being first may not mean much.Rivian indicates its factory in Illinois has the capacity to produce approximately 65,000 pickup trucks/SUVs and 85,000 commercial delivery vans, the latter of which is why Amazon is interested. Amazon owns 20% of Rivian and has ordered 100,000 Rivian vehicles to be delivered by 2030. Ford was also interested in collaborating on production for its EV business. The investment increased to become a meaningful part of Ford’s market capitalization, regardless of synergistic opportunities. However, on Friday, it was announced that Ford and Rivian had canceled their plans to jointly develop an EV.There are numerous potential reasons for this split, and Rivian indicated the decision to split was mutual. When Ford invested in Rivian in 2019, it was likely viewed as a way to jump-start its EV initiatives. Since then, Rivian’s production has been de minimis while Ford sold about 22,000 Mustang Mach E's alone in 2021, which was named Car and Driver’s Electric Vehicle of the Year. While Ford will continue to benefit from its investment in Rivian, it doesn’t “need” Rivian to be successful in EVs.Below, we have included a recent blog from my colleague Atticus Frank on Mercer Capital’s Family Business Advisory Services team, highlighting the decision to invest in Rivian from Ford’s perspective.Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) startup that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car startup, giving it an implied stake of over $18 billion. Not bad, given its sub-$1 billion of invested capital. If one were to do a “back-of-the-envelope” sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization. We don’t highlight the current irrational exuberance to spur you into investing in an EV startup or give you a case of ‘FOMO’, but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why? What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is a correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation. We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article. When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative. However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the startup) is yet to be seen. Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different ‘who’ regarding diversification and a different ‘why’ to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business. Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the ‘why’ for significant investment decisions. How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision. Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.“If I had asked people what they wanted, they would have said faster horses.”“Any customer can have a car painted any color that he wants so long as it is black.”Takeaways From RivianAuto dealers are unlikely to be able to invest in the next Rivian, but that doesn’t mean there are no lessons to be learned here. The market is clearly indicating it believes EVs are the future, so dealers should be positioning themselves accordingly. With heightened margins in 2021, auto dealers need to decide the best way to reinvest their capital. That may mean using profits earned in the past years and investing in infrastructure to support EVs. Local markets will still be necessary and there won’t be a one size fits all solution, but Rivian making headlines should get auto dealers thinking about what it means for them.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.In addition to auto dealers, Mercer Capital also provides financial education services and other strategic financial consulting to family businesses. Click here to learn more about our Family Business Advisory Services.

Differing Perspectives on the Used Vehicle Market

Feast or Famine?

With Thanksgiving around the corner next week, we hope that everyone will be able to visit with family, share a meal with loved ones, and rekindle old traditions from holidays past. All of us are not immune from the headlines that speak to disruptions in the global supply chain on a daily basis. Undoubtedly, each of us has been inconvenienced with those supply shortages with consumer products, food, and essential goods that impact our daily lives. The automobile market is no different.In a previous blog, we examined several key indicators for the entire automobile market incorporating the first six months of data. In this weeks’ blog, we offer commentary on the status of the used vehicle market and re-examine some of those metrics through third quarter data. Headlines persist describing inventory shortages, record transaction prices, record profitability and predictions for when conditions will return to normal. How do we make sense of all of it? What factors are contributing to the current conditions? Like the larger automotive industry as a whole, conditions can be described as the best of times and the worst of times, or feast or famine. Interpretation of the conditions can differ depending on the perspective of the consumer or the auto dealer. We examine some of the key used vehicle metrics and indicators and then discuss how we got here and where we are headed.PricesFeast for the Auto Dealers, Famine for the ConsumerAccording to Cox Automotive, the average transaction price for a used vehicle topped $27,000 for the month of September. This figure represents the largest average transaction price for used vehicles on record and indicates a 25% increase from the average price of used vehicles just one year ago in September 2020. Most car buyers understand the historical notion that the value of a car depreciates immediately after you drive it off of the dealership lot. In 2021, this notion simply isn’t true for the time being. There are plenty of examples in the marketplace of used vehicles that are 1-2 years old with minimal miles (25-30K) that are selling for prices higher than the original sticker price of the new vehicle!Gross Profit Per Unit Used VehicleFeast for the Auto Dealers, Famine for the ConsumerOf the department/profit centers for an auto dealership, historically, the new and used vehicle departments accounted for the largest contribution to revenue, but a substantially lower contribution to overall gross profit. According to the Average Dealership Profile from NADA, these departments typically comprised approximately 88-90% of revenues and approximately 52% of gross profits, with the remainder coming from fixed operations. Currently, these departments still comprise a similar percentage of total revenues but now comprise 60% of gross profits. This figure continues to climb as of September 2021 as reported by NADA. What is driving this increase? Rising transaction prices for used vehicles and, in turn, increased gross profit per unit (GPU). The graphic below details the current used vehicle GPU and the corresponding figures from the prior two year-ends.Average Days’ Supply Used VehiclesFamine for Auto Dealers and the ConsumerWe’ve written about average days’ supply previously in this blog, but it serves as a key indicator of the level of supply, or in this case, the shortage of used vehicles in the market. Average days’ supply is calculated as the number of used vehicles in inventory or in the market divided by the average daily number of used vehicles sold. Historically, this figure ranged between 55 and 66 for 2019 and 2020, as seen in the graphic below. The average days’ supply for used vehicles has not slumped nearly as bad as the same metric for new vehicles and has shown signs of steadying to slight improvement.Source: Cox AutomotiveThrough the early spring of 2021 and through September, this same metric cratered at 33 and has steadily maintained or slightly improved to 43.Source: Cox AutomotiveSourcing – Where do Used Vehicles Come From?To help explain the forces behind these metrics, let’s examine where used vehicles are sourced. Historically, used vehicles from an auto dealer were purchased from one of four areas: customer trade-ins, off-lease vehicles, fleet cars, and auctions.Trade-Ins – With plant shutdowns, microchip shortages, and supply chain issues, the supply of new vehicle inventory has been more adversely affected than its used vehicle counterpart. Average days’ supply for new vehicles dipped into the low 20s and dropped even lower for many local auto dealers. With fewer new vehicles to purchase, the number of customer trade-ins are also lower simply due to transaction volume and inventory availability.Off-Lease – Off-lease vehicles refer to a vehicle returned to a dealer at the end of its lease. Generally, off-lease vehicles have been gently used and tend to have lower mileage. Why are less leased cars being returned to the dealer? Most lease contracts have a clause where the consumer can purchase the vehicle at the end of the lease for a residual value. In most cases, the residual value is lower than the original value of the vehicle to reflect the depreciation of value.As discussed earlier, the value of used vehicles is at/near record highs. Many vehicles have a current value greater than the anticipated residual value stated in the original lease contract. Customers with leases face two choices: purchasing their vehicle for the residual value or returning the vehicle to the dealer at the end of the lease. Facing the inventory shortage conditions on both new and used vehicles and the prospect that the current value of their vehicle is greater than the residual value, most consumers are choosing to purchase the vehicle at the end of the lease. While others may purchase their leased vehicle and sell immediately to realize the arbitrage opportunity between the current value and residual value, most then face the prospect of locating and purchasing a more expensive vehicle. In either case, fewer off-lease vehicles are re-entering the used vehicle market.Fleet Cars – Fleet cars represent those vehicles sold to rental car companies, government agencies, or larger customer accounts. The trends affecting the current condition and the overall life cycle of these cars date back to the early days of the pandemic. In the Spring of 2020 with the advent of lockdowns and travel restrictions, rental car companies sold off much of their inventory which hit the used vehicle market at that time. Flash forward to the next 18 months that were characterized by plant shutdowns and lower sales by the OEMs in 2020, and then further inventory shortage issues caused by the lack of microchips and other factors in 2021.Historically, OEMs and the industry operated on an average days’ supply of new vehicles between 60-75. OEMs and auto dealers prioritized fleet sales with the extra inventory, as these contracts typically consisted of lower margins despite higher volumes. With the excess inventory being removed from the market, OEMs and auto dealers are now prioritizing direct consumers with the available inventory because they can achieve higher margins and offer fewer incentives. Fleet sales, and specifically rental car companies, have never been able to fully replenish their inventories. In turn, rental car companies no longer possess aging inventory that generally would get replaced and sold back into the used vehicle market. As a consequence, some rental companies are seeking to source their own used vehicles from auto auctions.The graphic below depicts total fleet sales from January through September for 2019, 2020, and 2021 as reported by Cox Automotive. While total fleet units are up slightly in 2021 from the same period in 2020, this figure is misleading when viewed in the context of more normal fleet sales in 2019. In fact, current year-to-date fleet sales are down nearly 41% over 2019 figures.Source: Cox AutomotiveAuto Auctions – Auto auctions are another source of used vehicles. The presence of auto auctions is also circular to the life cycle of the automobile. Auction cars come from various sources, including local car dealers, private sellers, police impounds, and bank repossessions. As detailed earlier in this post, the volume derived from the first two events has decreased simply due to the lack of overall transactions. Current economic conditions and forgiveness or grace periods have also led to fewer vehicles from the latter two events. If auto auctions are obtaining fewer cars, then auto dealers have fewer cars to potentially source from the auto auctions and the cycle and shortages continue.Predictions and ConclusionHow long can the good times (record profitability and margins) continue for the auto dealers and when will the bad times end for the consumer (high transaction prices and inventory shortages)? The simple answer is that they won’t continue like this forever, but no one knows when they will end. Many industry experts predict that the prevailing inventory and microchip shortages on the new vehicle side could last well into the first half or for the entire year in 2022 and beyond and will impact the used vehicle market for much of that time.For the used vehicle market, analysts at Black Book are predicting retail sales for the remainder of 2021 will equal or eclipse the levels for the same time period in 2019. Some analysts believe profit margins and transaction prices for used vehicles are already showing signs of moderating, despite some of those metrics still peaking. As a backdrop, 2019 is often considered by many as the best year ever for retail sales of used vehicles.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst all of the noise, contact a professional at Mercer Capital to perform a valuation or analysis. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry, and financial performance factors.

October 2021 SAAR

October 2021 SAAR was just shy of 13.0 million, as new light vehicle sales saw their first month-to-month gain since April. The October SAAR is up 6.3% from last month but remains 20.8% lower than last October. Auto dealers began the month with record low inventory levels of 972,000 units, and low inventories continue to keep car buying activity constrained. Dealers are pre-selling a significant amount of the new inventory they receive as they attempt to satisfy demand. According to Thomas King, President of Data and Analytics, nearly 54% of vehicles will be sold within 10 days of arriving at a dealership.As of now, there is no expectation that inventory on the lot will increase anytime soon. There is some optimism around the industry that inventory levels will slowly increase throughout 2022, but it is likely that these inventories will remain below pre-COVID levels for the foreseeable future. Based on our discussions with dealers and reading of the tea leaves, we think it’s reasonable OEMs will see heightened profits under the status quo and seek to structurally tweak how much inventory is kept on dealer’s lots going forward. In October, prices have continued to rise and OEM incentive spending has continued to fall. This has been the case for several months now, and dealers have been realizing record profitability on vehicles sold for some time. If it seems like there are new profitability records being set every month, it is because there have been. Average incentive spending per unit has hit another record low of $1,628 in October. Total retailer profit per unit is on pace to reach another record high of $5,129 as well, the metric’s first time above the $5,000 mark. For perspective, this is an increase of $2,937 (more than double) from a year ago, and total aggregate retailer profits, a measure of the industry’s profitability as a whole, is up 213% from October 2019, reaching $4.8 billion. This October was the most profitable October on record for auto dealers, and it is likely that November will yield some of the same, if not better, results. Inventory shortages and record profitability are not the only persistent conditions in which auto dealers are operating. Fleet sales continue to be outpaced by retail sales, accounting for only 142,000 units over the last month. Trucks and SUVs are on pace to account for a record high 80.9% of new vehicle retail sales in October as well. As far as new vehicle prices are concerned, transaction prices on the average new car reached another record high of $42,921. While supply and demand imbalance plays a role in these increasing prices, we note the mix of vehicles is also important. Trucks tend to be more expensive than cars, so the mix continuing to shift towards higher profit trucks leads to higher transaction prices. The moral of the story is that October proved to be more of the same for auto dealers across the country, and most dealers are still thriving in a low inventory–high price environment. Microchip Background and UpdateMany OEMs, dealers, and research analysts following the industry have been looking ahead to try and predict when the ongoing inventory shortage might begin to improve. As we have mentioned earlier in this blog and on previous blog posts, the current estimate seems to be around the middle of 2022 at least, depending on your definition of improvement. One important determinant that many are looking at is the state of the semiconductor industry.Semiconductors, referred to by many as microchips or chips, are the brains behind electronic devices. As more electronic devices are being produced each year around the globe, the semiconductor industry has struggled to keep pace with demand for some time now. The rise of 5G technology can be blamed for increased demand, as well as increased demand from industries that have traditionally been semiconductor-free (auto makers can be included here, although chips have been common in new vehicles for years now). Another driver of increased demand is the rising number of semiconductors needed per manufactured unit across the many affected industries. For example, just one car can have anywhere from 500 to 1,500 different semiconductors. As we discussed previously, the pandemic exacerbated issues with people stuck at home reaching for electronics as a means of entertainment.The increased demand mentioned above, paired with supply chain disruptions have set up the perfect storm for a semiconductor crisis. The crisis is hitting OEMs particularly hard, as many manufacturers are announcing major slowdowns and stoppages during the fourth quarter of 2021. We have not touched on the geopolitical ramifications of the semiconductor shortage, although the sourcing of these chips going forward will be an important factor to keep an eye on.Toyota Motor recently announced that it was on pace to produce 40% fewer cars and trucks in October as a result of the chip shortage. This marks the second month in a row that Toyota slashed production estimates. GM, Ford, and Stellantis, who have all dealt with intermittent shutdowns over the last 6 months, account for 855,000 units of reduced vehicle production. Particular models from these OEMs that have been severely affected are Ford F-Series trucks, the Jeep Cherokee, the Chevy Equinox, and Chevy Malibu. Given that this crisis is becoming the single most important factor in getting vehicles on dealer lots, many executives are being asked when they think the supply chain for semiconductors will reach pre-pandemic levels.A Volkswagen executive recently released a statement, saying that “Without a doubt, this shortage is going to go well into 2022, at least the second half of '22."Likewise, Ford CFO John Lawler said that Ford is “doing everything we can to get our hands on as many chips as we can. We do see the shortage running through 2022. It could extend into 2023, although we do anticipate that the scope and severity of that to reduce.”Executives of the other major OEMs are echoing these concerns as all OEMs face similar challenges in securing chips for their vehicle production. That being said, the industry is prepping for an extended waiting game and cannot do much to produce more units in the meantime than what is allowed by current semiconductor inventories. While auto dealers are bearing the brunt of consumer frustration over the higher prices and lower availability, at least profits are up.ForecastLooking ahead to next month and the remainder of the year, we expect that the sales pace of the industry will continue to be constrained by the procurement, production, and distribution problems outlined above. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot. However, the number of incoming units is not expected to materially change in November. Essentially, dealers can expect more of the same.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

NADA Is Busy Working on Capitol Hill on Behalf of Auto Dealers

In last week’s blog, we wrote about attending some of the Tennessee Automotive Association meetings and explored the buy/sell considerations discussed there. That topic is certainly timely for auto dealers, as record profits are the norm rather than the exception during the ongoing inventory shortages and supply chain disruptions. However, transaction considerations were not the only updates that attendees received. This week’s blog touches on federal legislation that NADA prioritizes and how that legislation could impact your dealership's operations.Tax Hikes That Impact DealershipsOne of NADA’s top priorities has always been to keep taxes low for dealerships, and that mission has not changed. In their outlined legislative priorities, NADA states that it is concerned that significant tax hikes will weaken the nation’s auto industry. Specifically, NADA is opposed to the tax structure currently laid out in the pending House Reconciliation Bill. Here is a breakdown of the potential tax changes included in the bill that could affect your dealership:Most auto dealerships are tax pass-through entities, and the current blended tax rate on pass-through earnings is about 29.6%. This tax rate accounts for the 20% Qualified Business Income (QBI) deduction, individual income taxes, and a Net Investment Income (NII) tax.According to NADA, if the House Reconciliation Bill were passed as proposed, the blended tax rate on pass-through earnings could be as high as 43.4%. The QBI deduction would reduce, corporate and individual income taxes would increase, and the NII tax would expand to essentially all pass-through income.From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lead to lower values for auto dealerships.No one wants to pay more than their fair share of taxes, and NADA is lobbying to improve the rates at which dealerships are exposed to them. Like all business owners, auto dealers would see lower after-tax proceeds that could be reinvested in their business. While NADA is lobbying on behalf of auto dealers, this is an issue that hits businesses across all industries, and it appears to be a legislative priority for the White House.From our perspective, we find it likely that taxes will increase from current levels, though just how much of an increase might occur and the timing of the increase remains to be seen. Dealers should be aware of the tax law changes and prepare accordingly. From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lower auto dealerships' values.Electric Vehicle Incentives Need to Work for DealersOn September 15th, the House of Representatives, Ways and Means Committee, approved a new electric vehicle incentive program as another part of the pending House Reconciliation Bill. This program supports tax credits to consumers for purchasing an electric vehicle and would increase the tax credit from $7,500 to $12,500. The bill would also make the tax credit “transferrable”, meaning that the dealership could claim the incentive and the consumer could treat that incentive as “cash on the hood”.NADA is concerned that dealerships are being asked to front-load the credit on these transactions and wants to make sure that the IRS pays the full value of these credits to dealerships in a timely manner. Dealers will remember this cash drag as an issue during the Cash for Clunkers program. Additionally, NADA wants to ensure that every franchised brand receives the benefits of these incentives, meaning that no one gets left out. From a valuation standpoint, we know certain brands change hands at higher blue sky multiples than others. If only certain brands were able to participate in a program that benefits dealerships, those brands could see better multiples in the short term.Further incentivizing consumers to purchase vehicles is almost always a positive thing for dealers. If the IRS is accurate and timely with its payment of EV credits, the program could be a success, but if credit payments become unreliable or too sluggish, dealers may choose not to participate in the program and lose sales to competitors.Treasury Should Grant Lifo Tax Relief for DealershipsLast November, NADA petitioned the Treasury Department to exercise its authority by allowing dealerships that use LIFO (Last-In, First-Out) inventory accounting to replace their new vehicle inventories over a three-year period. This request responds to LIFO recapture taxes that are expected to heavily impact dealers in the current environment of rising prices but declining inventories.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well.Many, though not all, auto dealers report their inventory on a LIFO basis. This typically leads to lower reported taxable income because inventories sold are based on the last price. In a typical inflationary environment, this means the cost of goods sold is higher under LIFO than FIFO.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well. However, during the recent supply shortages, inventory balances have dropped considerably, affecting dealers’ reported LIFO reserve more drastically than many dealers would expect.An example is provided below of how a dealer may have been impacted in 2020. However, because the supply chain issues have further devolved since this case was presented in December 2020, the income reported by dealers in 2021 is expected to be considerably higher due to accounting and not cash flow. Dealers should not hold their breath when it comes to the possibility of avoiding LIFO recapture taxes. The request was submitted by NADA a year ago and Treasury Department has not formally responded to the petition yet. While unique supply chain issues may be negative in the near-term, eventually inventory balances will rebuild, which would lower future tax bills. In essence, dealers on LIFO would be forced to pay taxes on front-loaded phony profits, which would eventually smooth out. Dealers that are subject to LIFO recapture could use the forgiveness as a chance to invest in replenishing inventory, EV infrastructure, and employee training. While this is clearly a negative for dealers, it is our understanding, legislators (generally speaking) would prefer to do away with LIFO entirely, so we do not anticipate much accommodation. It is more likely that subjected dealers should begin preparing for a larger-than-usual tax bill, though some options may exist. From a valuation standpoint, LIFO recapture is unlikely to impact valuations materially. Many valuation professionals already adjust to FIFO, so this would already be normalized whether it is positive or negative to cash flow in any particular period. As with many pieces of legislation or contemplated legislation, LIFO may impact the motivations of buyers and sellers, though it will have less impact on the determination of ongoing cash flows. ConclusionNADA is busy working on Capitol Hill on behalf of auto dealers, but the organization’s influence can only go so far. This makes it even more important that dealers know the legislative issues that could affect their dealership ahead of time and regularly communicate with their local politicians. Being proactive instead of reactive can make a big difference when running an auto dealership, making it worth the dealer’s time to stay plugged in.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The Tricks and Treats of the Buy/Sell Process from a Selling Dealer’s Perspective

Fall District Meeting Roundup

Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell. Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions? Is this a good time to sell or a bad time to sell? As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers. Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits. Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM? Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models? Is the OEM demanding additional image requirements? How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family? Is the perceived value of the dealership equal to or greater than the offers in the marketplace? Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex. A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership. Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction. Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM? Has the dealer recently completed an image requirement or are additional requirements pending? The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads. Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process. A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations. Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members? A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts. How long will they continue or are any set to expire? Key contracts would include the Dealer Management System (DMS) among others. Selling dealers must balance opposing factors with contracts: not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues? A selling dealer should complete an environmental survey at the beginning or during this process. Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance. Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities. If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships. Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases, a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Interpreting Inflation and Interest Rates for Auto Dealers

Can Retail Vehicle Prices Continue to Soar?

Inflation and interest rates are on more people's minds lately due to supply chain disruptions across all industries. People understand how inflation and interest rates affect their daily lives when noticing the rising cost of goods/services and the cost to borrow money to buy a house, but many don't realize that inflation and interest rates are interconnected. Inflation and interest rates are frequently linked when discussing macroeconomics and they tend to have an inverse relationship. When interest rates go up, in theory, inflation goes down. However, there are many more factors other than inflation and interest rates impacting the economy in the real world.In this post, we discuss how we got to our current reality, what auto dealers might expect regarding inflation and interest rates, and how it all might impact the dealership.How Did We Get Here?Back in April, Federal Reserve Chair Jerome Powell indicated the Fed wasn’t close to raising interest rates, labeling inflation as “transitory.” At the time, he cited strengthening economic indicators, including employment and household spending and continued vaccinations which were expected to ease uncertainty and continue the economic recovery.According to Powell, “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future.” Further, the Fed indicated that clogged supply chains would not affect Fed policy as they were seen as temporary and expected to resolve themselves.While this transitory stance appeared reasonable at the time, confidence in this stance has waned and the Fed has begun signaling it would end its accommodative policies. Below we’ve included the first chart and table in the September edition of the Consumer Price Index (“CPI”) published by the Bureau of Labor Statistics last Wednesday (October 13, 2021).Source: Bureau of Labor Statistics- Consumer Price Index-September 2021Source: Bureau of Labor Statistics- Consumer Price Index-September 2021In our view, the graph of 12-month change supports the transitory view, at least in the beginning. Comparing prices in April 2021 to April 2020 is not very meaningful given the significant impediments to the economy at the time. However, as seen in the tables above, inflation has persisted on a monthly basis over the past six months. While 0.3% and 0.4% growth in the past two months is an improvement over March through July, it shows that the problem continues to linger.Are inflationary pressures still expected to be brief and transitory?On Tuesday, the day before September inflation numbers were published, Atlanta Federal Reserve President Raphael Bostic indicated inflationary pressures “will not be brief” and that he and his staff would no longer refer to inflation as transitory. Notably, Bostic is a voting member of the 2021 Federal Open Market Committee, and his public statement is the first to our knowledge challenging the transitory narrative. However, it shows how the Fed has evolved its stance over the past six months.In March, the Fed signaled it wouldn’t raise the Federal Funds rate until at least 2024. In June, the Fed stood by its transitory stance but began to indicate rate hikes would come sooner as the dot plot of expectations from FOMC members indicated two rate hikes in 2023. By September, half of Fed policymakers are expected to start raising rates in 2022, as seen below. While the timing of rate hikes is uncertain, it appears that accommodative policy will be eased in the not so distant future. What does that mean for auto dealers? Impact of Inflation on Auto DealershipsNotably for auto dealers, used vehicle prices surged by over 10% month-over-month in both April and June, which accounted for about a third of the total increase in the CPI for those periods. According to Cox Automotive Chief Economist Jonathan Smoke back in July, used vehicles were “the poster child illustration for transitory price hikes." While used vehicle prices, according to the CPI, have come back down to Earth in recent months, including decreases of 1.5% and 0.7% in the past two months, new vehicles have seen monthly growth of at least 1.2% since May due to supply shortages.New and used vehicle retail prices continue to climb to all-time highs. Even despite lower volumes, dealers are seeing higher revenues. Through August 2021, the average dealership was getting $3,668 in retail gross profit per new vehicle retailed. Through April of this year, that figure was $2,906 indicating a widening of profits for dealers on a per unit basis. This has played a role in the outsized profits achieved by auto dealers in 2021, who are likely wondering how long this can last.In our view, prices will continue to rise in the short-term due to supply constraints. However, consumers are becoming increasingly aware of these higher costs, and new vehicle buyers are likely delaying purchases if they are able to wait. While businesses across all industries are able to point at supply shortages and COVID as reasons for higher prices right now, at some point buyers will leave the market to wait for prices to normalize.While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position because dealerships have numerous complimentary profit centers. But how long will it last?While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position. As we’ve discussed before, auto dealerships have numerous complimentary profit centers. If a customer can’t find the new vehicle they want, a deft salesman can get them into a used vehicle. When consumers delay purchases of a vehicle, they put more mileage on their current vehicle, driving business to the higher margin service and parts operations. With fewer vehicles put on the road in 2021 due to shortages, we see a runway for more vehicle sales, even if the profit per unit declines. In the medium term, parts and service may be the area to watch. Fewer vehicle sales means parts and service will eventually dip in the future, though this likely won’t be felt for a few years. It will also be interesting to see where consumers get their vehicles serviced after purchasing from online used vehicle retailers that don’t have these operations. Along with the factors already mentioned, the future path of inflation for vehicles will likely also be impacted and interconnect to the path taken by interest rates.Impact of Interest Rates on Auto DealershipsAccording to an interesting Lexington Law study on how Americans are buying cars, auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide. When interest rates fall to the prevailing low levels, consumers are able to afford more expensive cars. However, the mathematical movement of lower interest rates doesn’t necessarily mean consumers will correspondingly purchase a more expensive car. Similarly, when interest rates rise, that doesn’t mean vehicle prices have to decline. Still, dealers should be aware that this is the case, at least in theory.Interest rates matter. Auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide.In practice, F&I departments can smooth out rising interest rates or rising vehicle prices by extending the length of loans. According to Lexington Law study, the amount of the monthly payment was the top priority for the average car buyer. It is natural for people to consider their monthly out-of-pocket costs and what they can afford, even if it leads to a longer loan term or higher interest rates. We should also note that APR and total interest paid are similar considerations, which when combined, amount to almost half of the decision.Source: Lexington Law | Study: How Are Americans Buying Cars?Rising interest rates will increase costs to consumers and if they’re on a fixed budget, this places downward pressure on vehicle prices. In December 2015, the Fed raised rates for the first time since the Global Financial Criss. Dealers will have to lean on their past experience on how to navigate vehicle sales in an environment of rising interest rates. Interest rates don’t only affect top line revenues for dealerships, however. The prevailing low interest environment and inventory shortage has significantly reduced one key operating expense for auto dealerships: floor-plan interest expense. Lower interest rates mean the price of keeping inventory on the lot for test drives is lower. With lower levels of inventory, interest expense is being reduced by volume as well as price. With inventories expected to normalize and interest rates expected to creep up, auto dealers will see floor plan expenses rising. It may not get back to pre-COVID levels if OEMs structurally change the level of inventories kept on dealers’ lots, but that’s another topic for another blog post.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by the greater macroeconomic environment. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

September 2021 SAAR

September 2021 SAAR was 12.2 million, dropping for the fifth consecutive month amidst an ongoing inventory shortage. The September SAAR was the lowest since May 2020’s 12.1 million units but has not fallen near the COVID-19 pandemic low of 8.6 million units in April of 2020.Tight inventories limited both fleet and retail sales in September, which has been the same case over the last four months. Fleet sales continue to fall as a percent of total sales, making up just 12% over the last month, as higher profit retail sales continue to be prioritized.As mentioned in last month’s SAAR blog, auto dealers started the month with industry-wide record low inventory levels of 1.06 million units. Inventory levels have not improved much since then, but the industry inventory to sales ratio has modestly ticked up from 0.68 to 0.72. This could be explained by sales rates finally slowing down and keeping pace with production rates. High levels of demand and low supply have been coexisting for months, and there are only so many new vehicles to go around as consumers are increasingly pre-ordering vehicles before they even arrive on dealers’ lots. While high prices are keeping away certain customers that have decided to wait, wider margins are keeping dealers profitable. However, at current production rates there are only so many vehicles being produced by OEMs that can make it to the lot, and high trade-in values and wide margins can only do so much to bridge the gap for dealers that may not have a new car to sell to a potential trade-in customer down the line. In response to the current climate, average transaction prices have continued to rise. The average transaction price of a new vehicle is expected to top $42,800, another all-time high and the fourth straight month that prices have exceeded $40,000. Dealers have taken advantage of high prices to sustain profitability by achieving high margins on each vehicle sold for months now, and the factors involved continue to benefit dealers. For example, average incentive spending per unit is expected to reach another record low of $1,755 per vehicle, down from $1,823 a month ago, driving GPUs up even further. Another factor that influences dealer profitability, inventory turnover, decreased again as well. The average time that a new vehicle sat in the lot during September was 23 days, down from 25 days in August and 54 days in September 2020 reducing floor plan interest expense. What Do Tech Investments By OEMs Mean For My Dealership?In a previous blog outlining the different options that dealers have when allocating capital amidst excess liquidity, a few options were highlighted. Dealers can either 1) reinvest in the business, 2) return capital to debt and equity stakeholders or 3) seek acquisitions to drive growth. These fundamental decisions apply to OEMs as well, and over the last several months many OEMs have decided to reinvest in the core operations of the business by shifting their focus to electric vehicles.Listed below are narratives of some of the investments OEMs have made and how they might affect the value of your privately held dealership.Nissan has developed a new technique for assembling vehicles more efficiently and with less waste. This technique, called SUMO, enables Nissan to produce vehicles 10% cheaper than before, despite them manufacturing increasingly complex vehicles like hybrids and EVs.General Motors is developing a supply chain for rare-earth metals for the production of EVs, a move expected to pave the way for a more reliable stream of General Motors EVs in the future.Ford has also reinvested in EV operations, and has recently partnered with Electrify America, ChargePoint and others to bolster its charging network.Ford has also announced a state-of-the-art production facility that is set to be built in west Tennessee, creating 5,800 positions to produce electric F-150 trucks. The plant is also said to be a zero-waste-to-landfill facility. The point is that almost every major vehicle manufacturer is investing in the future of its EV production process, a move that some analysts think will lead to higher, Tesla-like, valuations. However, it is unclear whether OEMs will start to invest in support for dealership maintenance infrastructure. Many have already chosen to pass along the costs of investments needed for the sale and service of EV vehicles onto the dealer, creating several issues surrounding the economics of an upgrade for rural and smaller dealerships. Time will tell whether OEMs will choose to prioritize the amount of EVs on lots by further subsiding transition fees.ForecastLooking ahead to October, expectations for the full year 2021 SAAR have once again been lowered. Experts estimate that the global industry has already lost around 9 million units of production related to supply chain issues, and that number should continue to mount with no end in sight for OEMS until and likely into 2022. The demand for new and used vehicles is expected to remain feverish, but sales will have to contend with ongoing production constraints. Sales can no longer outpace production as inventory has been drawn down.At this point, we are pretty confident sales in Q4 won’t be high enough to reach our initial 2021 target. Despite a challenging year from an operational standpoint, we doubt many dealers will be complaining with the results and the profits achieved this year.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

September Acquisitions by Sonic, Asbury, and Group 1 and What They Mean for Privately Held Auto Dealerships

Smallest Public Players Getting Larger

In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo. Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Tax/Estate Planning Cheat Sheet for Auto Dealers

Winds of Change?

Benjamin Franklin famously said that the only things certain in this life are death and taxes. While both may be certain, taxes are always subject to change.Last fall, we wrote a blog post about the estate planning environment for auto dealers and other industries. In that post, we highlighted the prevailing conditions that existed in the marketplace that would enable auto dealers to capitalize on executing any estate planning opportunities. Those conditions included opportunities for depressed valuations caused by uncertain operational results (at the time), low interest rates, and changing political forces caused by the Presidential election.Fast forward to Fall 2021 and while some of these conditions have changed, rumors of potential tax changes have finally re-surfaced nearly three-fourths of the way through the first year of the Biden Administration.Earlier this month, President Biden and Congress introduced the Build Back Better Act (“BBB Act”). After its introduction, the House Ways and Means Committee commented and circulated a draft of many of the proposed policies. A brief synopsis of the entire BBB Act from BKD CPAs and Advisors is provided here.In this post, we focus on four particular proposals that impact estate planning and business valuations for auto dealers (and other industries): 1) Estate Tax / Lifetime Exclusion; 2) Corporate Income Tax Rates; 3) Capital Gains Rates; and 4) Valuation Discounts for Passive Assets.Estate Tax/Lifetime Exclusion AmountThe Estate Tax / Lifetime Exclusion Amount is also referred to as the Generation Skipping Transfer Tax Exemption. This concept consists of the amount of an estate that is subject to be transferred free from taxes either during the lifetime of an individual/couple or at death.Current Status: $11.7 million per individual or $23.4 million for a married couple as stated in the Tax Cuts and Jobs Act (“TCJA”) for gifts made between January 1, 2018 and December 31, 2025. Based on these figures, all estates under these amounts can be transferred during the lifetime or at death without incurring any estate taxes.Current Proposal: Revert back to $5 million per individual adjusted for inflation to arrive at a figure of approximately $6.02 million per person or $12.04 million for a married couple.Effective Date of Change: January 1, 2022Valuation Impact: If enacted, the current proposal would now lower the lifetime annual exemption to $12.04 million for married couples, nearly cutting the exclusion in half. Estates with a value over $12.04 million would now be subject to tax on the amount exceeding $12.04 million.Who Should Consider: Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the BBB Act is passed. Current estates with values exceeding $23.4 million or those estates that have not utilized the full prior lifetime annual exclusion amount, should also consider executing estate planning strategies before that heightened amount is reduced. The reduced exclusion amount also increases the number of affected people. Someone owning a business worth $15 million could now benefit from tax planning strategies that previously may have been less concerned when they fell below the threshold established by the TCJA.Corporate Income Tax RatesCorporate income tax rates are the amount of taxes paid on profits earned by a corporation.Current Status: Flat rate of 21%, reduced by the TCJALatest Proposal: Graduated rates with a top rate of 26.5%Effective Date: January 1, 2022Valuation Impact: Business valuations of auto dealerships are generally impacted by three broad overall assumptions: expected annual cash flows, growth of said cash flows, and risks to achieve those cash flows. A proposed increase in the corporate income taxes would reduce the annual cash flows of an auto dealership simply by the fact that income tax rates are higher. We saw the reverse of this trend when income tax rates were lowered by the TCJA. While many auto dealerships are organized in entities that consist of S Corporations, Limited Liability Companies, and Partnerships, the corporate income tax assumption still impacts the business valuation. We won’t belabor the mechanics of a business valuation in this post, but effectively the hypothetical earnings of a business are tax affected to a C Corporation equivalent basis since the assumptions for the discount and capitalization rates (the risks associated with achieving expected cash flows) are derived from public C Corporations.Who Should Consider: As briefly discussed above, income tax rates comprise one of the assumptions in a business valuation. On its surface, the proposed increase in corporate income taxes will certainly reduce expected the after-tax earnings of an auto dealership, all other things being equal. However, other prevailing industry conditions, such as heightened profitability due to operational efficiencies, might mitigate the overall impact caused by increased tax rates. The opposite was true in 2017.Capital Gains Tax RateThe capital gains rate is the tax rate paid on the disposition of an asset. Rates can differ based on the holding period of the asset prior to disposition and are often bifurcated into short-term (one year or less) or long-term (longer than one year) rates.Current Status: Rates of 15% to 20% + 3.8% surtax on net investment incomeLatest Proposal: Top rate of 25% + 3.8% surtax on net investment income for tax year 2022Effective Date: Transactions occurring after September 13, 2021, would be subject to new rates. Transactions occurring prior to September 13, 2021 would be subject to current rates.Valuation Impact: Most business valuations do not calculate or consider the net amount received after a sale or disposition of the company or asset because the premise of these valuations is a going concern. However, we know business owners are definitely interested in the proceeds that ultimately hit their bank account.Who Should Consider: Auto dealers that are contemplating whether to sell their dealership or continue to hold and operate should consider this potential rate increase. Dealers are currently experiencing record profits but also face challenges with the inventory shortages caused by suspended manufacturing from the pandemic and the microchip shortage. While it can be hard to let go when profits are rolling in, there are long term concerns surrounding the increasing capital costs of developing and maintaining digital platforms to compete with the public auto groups and larger private groups. Many dealers are choosing to sell, as evidenced by the current white hot auto dealer M&A market. If the BBB Act passes, auto dealers that sell in 2022 can expect fewer after-tax dollars from a sale or disposition due to higher capital gains tax rates, all other things being equal.Valuation Discounts for Passive AssetsBusiness valuations of auto dealerships, real estate holding companies, and related businesses typically consist of determining the value of the entire business, as well as the value of a particular interest in the business. Often the subject interest comprises less than 100% of the total business and exhibits elements of lack of control and marketability. As such, discounts for lack of control, lack of marketability, and lack of voting rights are often applicable and determined to reduce the fair market value of the overall pro rata value of the subject interest.Current Status: Valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.Latest Proposal: The current version of the BBB Act proposes to eliminate valuation discounts for an entity’s “non-business,” or passive, assets. The BBB Act defines “non-business” or passive assets as cash, marketable securities, equity in another entity, real estate, etc. Further, passive assets are those assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. Passive assets which are held as part of the reasonably required working capital of a trade or business are also excluded. Real property is excluded from this rule if real property assets are used in the active conduct of real property trade or business in which the transferor actively and materially participates. Examples include real property used for rental, operation, and management, among others.Effective Date: January 1, 2022Valuation Impact: In a world where combined discounts for lack of control and marketability can range from 25-45%, this is a material impact. Passage of this piece of the legislation in its current form may not have a dramatic impact on the business valuation of dealership operations, which would still be subject to discounts. However, many auto dealerships carry excess cash or working capital in order to smoothly run operations or provide cushions in down periods. If the BBB Act were to interpret that all cash or working capital exceeds the “guide” figure on the dealer financial statement, this could inflate both the total value of the business as well as the portion attributable to passive assets, which would not be subject to discounts. Many auto dealers currently hold heightened levels of cash and marketable securities as a result of increased profitability and retainage of any PPP funds and loan forgiveness. Many of our auto dealer clients also own the operating real estate for the dealership in a separate asset holding company. These proposed rules could also jeopardize the applicable discounts for lack of control and marketability in those entities for any marketable securities or “non-business” or passive assets.Who Should Consider: If these discounts are eliminated for “non-business” or passive assets, auto dealers owning both types of entities, operating dealerships and real estate holding companies, should consider implementing and executing estate planning strategies. If all the discounts (not likely) or the discounts on “non-business” or passive assets are eliminated, the resulting business valuation of a subject interest in either of these types of entities will be dramatically higher. In turn, the overall values of the estates of auto dealers or the net value of transfers could be greatly increased for transfer tax purposes.ConclusionsJust as death and taxes are the only certain things in life, another relevant adage is that change is inevitable. As the BBB Act and proposals from the House Ways and Means Committee start to evolve, there are numerous tax and estate planning implications.While the final version of the Act will look almost certainly different than the current proposals for each provision, changes to existing rates and policies are anticipated. Fall 2021 is shaping up to be a busy estate planning season.Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equal. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.

Public Auto Dealer Profiles: Sonic Automotive

As we discussed in the first installment of this blog series, there are six primary publicly traded companies that own approximately 923 new vehicle franchised dealerships as of Q2 2021, or 5.6% of the total number of dealerships in the U.S. (16,623 at year-end 2020 per NADA). This demonstrates how fragmented the industry continues to be, despite recent consolidation.The total number of dealerships has remained largely the same, though the number of dealers is dwindling as big shifts towards e-commerce accelerated by the pandemic require heavier investment for smaller operations to compete.This issue of consolidation is not limited to just mom and pop stores.According to the Wall Street Journal, Suburban Collection of Michigan sold to Lithia this year in part due to the need for outside capital. David Fischer Jr. and his father sought a strategic partner to update their business to the new digital retailing environment despite having 56 franchises across 34 stores. In 2020, Suburban Collection was the 21st ranked auto group in terms of size, retailing just under 30 thousand new vehicle units.Given current blue sky values, the size of the deal and Lithia’s aggressive acquisition strategy, we realize premium pricing may have ultimately won the day in the Fischers’ decision to divest. Still, for an auto group of that size to be seeking a minority partner, prior to eventually being acquired, is noteworthy. We’ve also heard concerns from our clients that the potential for rising taxes and tweaks to the supply chain (with OEMs considering a model that reduces the autonomy of dealers) could lead to further consolidation.Our goal with these posts is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit in benchmarking to public auto dealers. Smaller or single point franchises may find better peers in the average information reported in NADA’s dealership financial profiles or more regional 20 Group reports. Public auto dealers also give dealers insight to how the market prices their earnings, the environment for M&A, and trends in the industry.Sonic Automotive Locations and BrandsBased in Charlotte, North Carolina, Sonic has 84 franchised dealerships, the lowest of any publicly traded company that operates principally as a new vehicle dealer. As seen below, the company earned over 50% of its revenue in Texas and California, with another 30% of 2020 revenue coming from Colorado, Tennessee, Florida, and Alabama. By year-end 2021, the company projects 25% population coverage. While the company is smaller and relatively concentrated in terms of its footprint compared to its public peers, Sonic is targeting 90% population coverage by 2025 (see projection below in recent investor materials). This growth will largely come from its EchoPark segment comprised of physical locations selling pre-owned “nearly new” vehicles with many having remaining OEM warranty. According to the Automotive News Top 150, Sonic sold the seventh most new retail units in 2020, at just over 93 thousand, trailing the other public dealers and Hendrick Automotive Group, the largest private auto group, also based in Charlotte. As seen in the table below, 55% of Sonic’s 2020 revenues came from Luxury brands, particularly BMW and Mercedes. This is more than double the company’s combined sales from domestic (10%) and EchoPark (15%), which are assumed to target a lower price point. Assuming continued growth in EchoPark, Sonic appears to be targeting consumers at various income levels which should provide balance in any market environment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. Sonic’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume based incentive fees, operating income can be negative for dealers before accounting for these profits.Due to differences in reporting, Sonic captures other income along with F&I as a revenue item with no corresponding cost of sales line item. The minimal amount of reported other income/expense not included as revenue if added to gross profit, would not change its reported gross margin of 14.85% by one basis point.Interestingly, its gross margin through the first half of 2021 was down immaterially from 14.89% in 2020. This comes despite industry-wide improvement in gross margins and a pickup in margin for new vehicles, whole vehicles, and parts, service and collision operations. That means Sonic has been negatively impacted by its declining margins on used vehicles (2.8% compared to 3.6%) and/or the contribution of gross profit (relatively less high margin fixed operations and/or more used vehicles).While EchoPark likely explains this, it is interesting to contrast to the average dealership as reported by NADA which saw gross margin improve from 11.8% to 13.4% in the first half of 2021. While this appears lower than the figures reported by Sonic, we note the difference between operating profit and pre-tax profits (largely aforementioned back-end profits) was 2.3% of revenues, which added to gross margin, would be 15.7%.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on Sonic Automotive. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Sonic’s Blue Sky value per share is approximately $35.19.Given recent outperformance, Haig Partners prescribes a 3-year average be taken in determining ongoing pre-tax income (2018, 2019, and LTM June 30, 2021). Using this methodology and applying the 25% tax rate implied by Sonic’s financials, its ongoing pre-tax earnings per share would be $4.97 or just over 7.0x Blue Sky. While this is lower than all of its public counterparts besides Group 1 Automotive, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential as well as its tilt towards luxury brands. ConclusionAt first glance, Sonic may appear to be a close comparable for private auto groups. Unlike other public auto dealers, it does not have other business lines (Penske) or international operations (Group 1). It’s not rapidly acquiring other dealerships (Lithia) and its franchised dealership count is about a third of AutoNation. However, like Asbury, it is tilted towards luxury with very little domestic sales, and still has significantly more dealerships than most groups.Sonic also has meaningful used-only operations in EchoPark, which is where the company is allocating much of its capital. Geographic diversification and access to capital markets can also materially impact comparisons, particularly for smaller dealerships. Still, management commentary on the macro environment in the auto dealer space is valuable and appropriate benchmarking comparisons are still possible if you know what you’re looking for.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers, gives us insight to the market that may exist for a private dealership. 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.

M&A, Reinvesting in Core Operations, or Paying Dividends

How Public and Private Dealerships Should Think About Allocating Capital Amidst Excess Liquidity

Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely. OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements. Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support 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.

Q2 2021 Earnings Calls

Public Auto Dealers Weigh Record Profits, Days’ Supply, and Capital Allocation

Second quarter earnings calls across the group of public auto dealers began with similar themes: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit.Executives revisited the reductions in personnel expense and their sustainability as GPUs are expected to decline at some point in the future. In a previousblog post, we discussed the prevailing industry conditions in inventory as reflected in the average days’ supply of new and used vehicles. The table below displays SG&A expense as a percentage of gross profit and the average days’ supply for the public auto companies for the second quarter:Click here to expand the image aboveThe trends reported by the public franchised dealers mirror those of the industry as a whole: continued tightening on the new vehicle side, but improvements on used vehicles. Executives offered their predictions for how the OEMs and the industry might evolve to supplying new vehicles once plant production and the microchip crisis normalize. Executives also discussed the ability to leverage their dealership platforms to source used vehicles from several sources including trade-ins, lease returns and campaigns such as “We’ll Buy Your Car” by AutoNation. As a result, the public franchised dealers are less reliant on auctions for used vehicle sourcing and are seeing some improvement in their used vehicle counts.Last week’s blogexamined the investment thesis and results of used-only public retailers such as CarMax, Carvana, Shift and Vroom. With record profits and a red hot M&A market, public executives discussed the opportunities for capital allocation and how they are evaluating and prioritizing the best fit for their companies. Three of the public companies in particular, AutoNation, Sonic and Penske, have chosen to invest in their used vehicle supercenter locations branded as AutoNation USA, EchoPark, and CarShop, respectively.Sonic provided some insight into the overall strategy of its used-only retail locations in its second quarter investor presentation. While front-end GPUs are expected to be lower (and sometimes negative) at the EchoPark locations, executives expect superior returns to be driven by the increased F&I GPU and overall volume of transactions at these platforms, compared to their franchised dealerships. These investments and strategies combined with other omnichannel investments by all of the public companies are in an attempt to capture the overall trend of an online retail experience.A deeper dive into some of the themes listed above is provided below, including remarks from management, related to expectations moving forward.Theme 1: The public companies continue to post improvements in SG&A as a percentage of Gross Profits driven by both sides of the equation: decreased expenses and record gross profits. While gross margins are universally expected to decline at some point, the jury is out on sustainability of cost reductions?“Our strong performance continues to be driven by strict cost discipline, leverage of our digital capabilities and robust vehicle margins. […] overhead decreased by 760 basis points, compensation decreased by 380 basis points, and advertising decreased by 30 basis points on a year-over-year basis […] I think for this year we will be in around the 60% range […] over 90% [of the increase in SG&A] is coming through variable cost. We are doing a very good job of keeping the fixed costs fixed, with strong discipline and leveraging the digital tools that we have” – Joe Lower, CFO, AutoNation“Same store SG&A to gross profit was 56.4% in the quarter, an improvement of 1,440 basis points over 2019. While we expect SG&A to gross profit to normalize [as] new vehicle supply and gross margins bounce back to historical levels […] we continue to benefit from the permanent headcount reductions of almost 20% or almost 300 basis points of SG&A and other efficiency measures implemented last year.” - Christopher Holzshu, COO of Lithia Motors“Obviously if growth comes down, that impacts SG&A…we’ve taken 11.5% of our workforce out […] we’re finding out we’ve got better productivity. Our mechanics are all over 120%. We see sales now per unit for a sales associate going from 9% to maybe 12% or 13%.” – Roger Penske, CEO Penske Automotive Group“If you look at our productivity on our sales associates […] we used to sell 12 units per month […] now we’re running 18,19. […] the other one [cost saving] is centralization of advertising […] we’re spending a lot less on advertising, and it’s even more effective.” - Heath Byrd Chief Financial Officer, Sonic AutomotiveTheme 2: Public executives boast of continued improvements in their omnichannel/digital platforms displaying that customer behaviors justify the infrastructure costs from these platforms. Advancements are illustrated in unique number of visitors, online transactions, and increased use of DocuSign and other electronic forms of signature software. Digital channels also allow the public companies to expand their footprint.“Our customers continue to vote yes on Acceleride […] we continued our upward trajectory in the second quarter by selling a record 5,600 vehicles through Acceleride, more than double the prior year. […] when incorporating all steps of the sales process, nearly 30% of our customers are using Acceleride. […] there’s opportunity to leverage Acceleride to expand our used vehicle business through our existing footprint […] in this quarter, we acquired almost 4,000 units through Acceleride […] and that was in a lot of markets that we’re not in today.” - Darryl Kenningham, President of US and Brazilian Operations, Group 1 Automotive“Driveway generated over 350,000 monthly unique visitors in June. Driveway eclipsed the 500-unit milestone with 550 transactions in June […] 98% of our Driveway customers during our second quarter were incremental and have never done business with Lithia or Driveway before […] we can now market and deliver our 57,000 vehicle inventory to the entire country under a single brand name and negotiation free experience […] 97.5% of customers in Driveway are entirely new to Lithia and Driveway […] we are delivering cars at a lot further radius […] last quarter we were at 740 miles or so […] we’re at 930 miles [because of] scarcity in vehicles." - Bryan DeBoer, CEO and President, Lithia MotorsTheme 3: A frenzied M&A market and heightened valuations have forced public executives to be more disciplined in their capital allocation approaches. Some of the publics (AutoNation, Group 1 and Penske) have prioritized share repurchases, others (AutoNation, Sonic) have prioritized reinvestment into their existing used vehicle platforms, while all must constantly evaluate acquisition opportunities against their individual growth, geographic and rate of return requirements.“A lot of different sellers that would like to work multiples off of Covid earnings. […] in the last six months [we] have walked away from $3 billion or $4 billion in business because we didn’t feel like it was priced appropriately.” – David Hult, President and CEO, Asbury Automotive Group“We’re investing in our existing stores […] keeping them top-notch […] but when we see that AutoNation is an attractive price, we have not hesitated to buy aggressively […] we view purchasing our own company relative to the pricing we see as other choices as the best use of that capital after having taken care of investing in our existing stores and building out [AutoNation] USA. […] I bought 9% of AutoNation rather than doing a lot of acquisitions that I thought were overpriced.” – Mike Jackson, CEO, AutoNation“During the second quarter, we repurchased 125,000 shares […] while the first priority for capital allocation remains M&A, we continue to be open to returning cash to our shareholders in the form of both share repurchases and an increase in our quarterly dividend. […] But the acquisition market is probably as frothy as it’s ever been […] it’s best if our acquisitions are accretive […] so we’re going to keep that as our top priority for capital allocation […] I would say it’s clear that share buybacks have been our second priority when we’re not able to find acquisitions to meet our financial hurdle.” – Daniel McHenry, Senior VP and CFO, and Earl Hesterberg, President and CEO, Group 1 Automotive“Despite a slightly more competitive environment, we continue to successfully target after tax returns of 15% plus, investments of 15% to 30% of revenues, and three to seven times EBITDA […] potential acquisitions that we believe are priced to meet our return thresholds […] we are expecting acquisition cadence for the remainder of 2021 to be strong.” - Bryan DeBoer, CEO and President, Lithia MotorsTheme 4: While average days’ supply on used vehicles is beginning to improve, the supply of new vehicles still remains near record lows due to production challenges from plant shutdowns, microchip shortages and increased consumer demand. Public and private franchised dealers have navigated these conditions to record profits. Will the current levels of production and inventory supply prove transitory, or will the OEMs adapt to the current conditions that one executive compared to the aphorism “rising tides raise all boats”.“I’m hopeful that when things normalize, we don’t quite settle back at the 70-80 day supply, we’ve run a good 20 days below that. […] OEMs are building the inventory the consumer wants.” - David Hult, President and CEO, and Dan Clara, SVP of Operations, Asbury Automotive Group, Inc.“The manufacturers […] are using the chips that they do have to produce vehicles that consumers want [to] buy. […] I really don’t know if we will ever see a crossover point back to the old push system […] maybe the best path is somewhere in between. […] it’s not 14 days […] but maybe its 30-40 days […] somewhere like we run pre-owned […] I was expressing more of a hope of where the industry would see as a new goal and not going back to the 70,75,80, 90 days’ worth of inventory. […] I have never been a strong proponent or advocate of the build-to-order model […] People are getting 95%, 98% of what they really want in a relatively short period of time of 30 days to 45 days.” - Mike Jackson, CEO, AutoNation“With our geography, we’re very big truck retailers […] You traditionally carry a pretty high day supply of those domestic brands because of the proliferation of models on full-size pickup trucks […] so if we could run a leaner distribution system, it would really reduce our inventory carrying costs and our land requirements.” – Earl Hesterberg, President and CEO, Group 1 Automotive“I think there’s a big wave between 60-70 days supply and a zero-day supply […] even at a 23-day supply, customers are able to get immediate gratification […] this idea that you’re going to have 100 cars to choose from that are all quite similar, that Americans seem to like […] I think consumers will ultimately determine that by not buying cars on the lot that are run of the mill and rather get that additional individuality that maybe they’re looking for.” - Bryan DeBoer, CEO, Lithia Motors“The big question there is can we keep the discipline at the OEM level from the standpoint of days’ supply in the 30 to 40 days […] and see what it does for them from a profitability standpoint. And obviously it’s been key for us at the dealer level.[….][OEMs] understand that their costs are down on supporting inventories […] if they start building units to fill these plants that aren’t the ones that customers want we’re then going to see an inventory pickup of vehicles that are not ones that people want to buy and then it’s going to start bouncing back in the same direction we were before.” - Roger Penske, CEO, Penske AutomotiveTheme 5: With the proliferation of Electronic Vehicles (EVs), private franchised dealers are left wondering what their involvement will be from the retail and service side. Most of the public executives envision the continued use of the dealer franchise system for EVs as opposed to a direct to consumer model.“The best model of supply [EVs] to the consumer is through the dealer franchise system. These cars are very complex, people need to be able to communicate locally [….] the highest dollar spent [in the service department] on electric vehicles […] its first generation technology, there’s a lot of software glitches […] we’re already working them into our collision center […] over time […] they still need brakes, batteries….[…] we’ve made a lot of investments already and we’ll continue to make more investments both in physical training and equipment.” - David Hult, President and CEO, Asbury Automotive Group“The complexity of the automobile is going exponentially. And that when there are issues […] the number of entities that actually can care for it and fix it are fewer and fewer. And that we look at only the electric vehicles, the investments we are having to make in specialty equipment and technical training. Expertise is unbelievable in the connected [EV] car.” - Mike Jackson, CEO, AutoNation“We’re supporting our OEMs with EV. EV is going to be driven by political [forces] […] from a dealership standpoint, until we get a significant market of EVs, I don’t see a big issue from the standpoint of parts and service growth. It’s going to take a different technician…because of the technology. […] the warranty [work] will have to be done by us and we’ll also obviously have to deal with the complexity.” – Roger Penske, CEO, Penske AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation and litigation support 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.

Used Vehicle Margins in 2021

How Large Used-Only Auto Retailers Are Measuring Up

As our dealer clients know, automotive retailing competition has intensified with large, well-capitalized online-only retailers getting plenty of attention. Due to imbalances between supply and demand, gross margins on both new and used vehicles have increased in 2021.In this post, we survey gross margins for the publicly traded dealerships, in light of the current operating environment and reconsider the investment thesis put forth by the new entrants.Investment Thesis of Online Used-Only RetailersInvestors in used-only retailers likely have numerous reasons for believing in these companies. We’ll highlight some of the reasons below, then delve deeper into a few of them.Lack of franchise agreements in used vehicle space enable significant growth/market reachCOVID-19 anticipated to accelerate auto retailing towards e-commerce seen in other retail sectorsCustomer dissatisfaction with traditional retail experienceGross margins tend to be higher on used vehicles than new vehiclesAsset-light business modelLack of Franchise AgreementsFor the publicly traded traditional auto retailers, franchise agreements can inhibit growth. Executives have discussed on earnings calls the obstacles that can occur when they accumulate numerous stores in the same brand. For used-only retailers, there are no similar restrictions as the sale of used vehicles are not subject to franchise agreements. While this may be a positive for growth and geographic diversification, this limits the market available to these companies.Vroom’s 2020 investor deck highlighted used auto as one of the largest markets at $840B trailed by grocery ($683B) and new auto ($636B). Using these figures (which are pre-pandemic), used-only players are limited to ~57% of the market.While growing to become the premier used vehicle operator would have obvious benefits, if any of these players can meaningfully consolidate the highly fragmented market, there is a downside to only interacting with consumers when they want a used vehicle. This is also why executives of franchised auto dealers have started harping on the number of "touch-points" they have with consumers which includes new and used sales as well as service appointments. source: Vroom, Inc.COVID-19 and the Shift to EcommerceA core strength of pre-pandemic automotive retail was the lack of penetration from ecommerce. As seen above, ecommerce penetration prior to the pandemic was less than 1% as determined by Vroom. The space has been Amazon-proof to a degree, though auto dealers and consumers were thrust into a digital world last March and April. Over a year later, it seems clear that the number of transactions and the percentage of transactions completed online will increase.Online retailers tout that they are the future, and the pandemic has only accelerated trends in consumer preference towards online. Only time will tell how truly transformed the environment is. Does the lack of ecommerce penetration represent a massive opportunity for new entrants in the market, or does it just paint a picture of how difficult it will be for these companies to attract profitable market share?Gross Margins and Profitability at LargeAnother long-term key consideration will be profitability. As with Amazon and Facebook, tech companies can command huge valuations prior to turning profitable. Many Silicon Valley startups claim to be the next unicorn that will achieve scale, ramp down expenses relative to revenue growth, and watch red ink turn to black.Because Carvana, Shift, and Vroom are still relatively young companies, their lack of profitability has not yet detracted from their value. However, gross margins can still be compared because companies spending significant amounts on advertising will have a hard time turning the corner if the unit level economics aren’t there.Let’s revisit what was mentioned at the outset. Used vehicle margins have been stronger than new vehicle margins. That remains to be true. Gross profit margin for the average dealership through the first half of 2021 was 13.4%, up from 11.8% through 1H20. For the new vehicle department, gross as a percentage of selling price increased to 8.3% YTD 2021, up significantly from 5.5% in the prior year period. The same is true for used vehicles: 14.0% YTD 2021 versus 11.4% in 2020. New and used margins are up in 2021, and used margins continue to outpace new.Parts and service departments have higher margins than vehicle sales departments, and these departments account for a significant portion of gross profit for auto dealers. According to NADA, through the first half of 2021, gross profit contribution from parts and service was considerably lower than historical levels (37.4% of total gross profit), but it still outpaced that of both new and used vehicle departments despite making up a much lower percentage of revenue. Below, we have calculated gross margins in 2021 for the public auto dealers.Click here to expand the image aboveUsed vehicle gross margins exceed new vehicle gross margins for Asbury, AutoNation, Group 1, and Lithia. Notably, however, that is not the case for Penske, LMP, or Sonic. Sonic’s 2.8% used vehicle gross margin stands out as an outlier, but we do see here that used vehicle gross margins are not exclusively higher than new. This could be due to the difficulty of sourcing vehicles in this environment.LMP and Penske also have the highest new vehicle margins, which could be at the detriment of used vehicles margins if they extract higher ASPs on new vehicles by offering higher trade in values.For total gross margin, however, the impact of fixed operations is clear. Blended total gross margin for traditional franchised auto dealers is approximately 15-18%. For used-only retailers, used and total gross margins are much lower as seen below.Click here to expand the image abovePerhaps these retailers are underpricing their vehicles to gain market share, and it is true that lost incremental vehicle sales from these retailers has a compounding effect. In addition to a lost vehicle sale, consumers are also less likely to go to a dealership for parts and service if they didn’t originally purchase the vehicle from that dealership. While this could have a long-term negative impact on total gross profit for dealerships, it remains to be seen if there will be mass adoption to buying vehicles from these platforms. Unless there is a material change in franchise laws, these companies won’t be able to sell new vehicles.ConclusionUsed-only online retailers may be the future. Customer dissatisfaction with "the old way" may push more people to try something new. The Carvana's of the world may improve their gross margins with data-driven technologies lowering costs and tactfully raising prices without losing their new customers.The asset-light model may help attract enough investors to lower the cost of capital for larger players enabling a virtuous cycle of greater scale and efficiencies. These players may eventually also look to get into the service and parts business to improve gross margins, though this would be hard to square with an asset-light approach.For now, though, franchised auto dealers will continue to operate with the strong foothold afforded to new vehicle dealers that can cater to customers throughout the life cycle of their vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

July 2021 SAAR

The July 2021 SAAR was 14.8 million units, roughly flat compared to July 2020, but down 12% from July 2019. SAAR was expected to fall for the third straight month, but this figure is lower than many experts predicted in June. As far as contributing factors to this slip, automotive manufacturers continue to struggle producing enough vehicles to meet insatiable demand that is emptying car lots around the country. Inventories continue to be drawn down and consumers are beginning to abandon their preferred color and trim selections as well as their preferred model and production year in favor of similar vehicles simply because they are actually available for purchase.As we detailed in last week’s blog, retail sales have crowded out fleet sales with an estimated 90% of total sales volumes in July, and this trend is also expected to continue as dealers no longer need to sell larger blocks of inventory at discounted prices. Dealers are doing everything they can to get new cars in the hands of consumers, as elevated prices continue to boost profits on a per unit basis.The average new-vehicle retail transaction price in July is expected to reach a record $41,044. The previous high for any month, $39,942, was set last month in June. Dealers are also capturing a greater share of these transactions prices as average incentive spending per unit, a measure of financial inducement used by manufacturers to motivate sales of specific vehicles, is expected to fall to $2,065, down from $4,235 in July 2020 and $4,069 in July of 2019. However, this doesn’t necessarily translate to skyrocketing costs for consumers as high trade-in values and low interest rates mean average new vehicle monthly payments of $622in July are only up 6.4% while transaction prices have increased 17%.Despite lower volumes, dealers are seeing record revenue levels as supply/demand imbalances have led to these surging prices. It also illustrates the relatively inelastic demand for consumers. Record vehicle prices have been noted across mainstream media outlets, yet customers continue to buy what little inventory dealers have. Consumers who can wait to buy a vehicle may be starting to hold off. But for those returning to the office in the wake of a public health crisis, there may not be many functional alternatives to personal vehicles. As noted above, monthly vehicle payments also haven’t surged as much as sticker prices.The trends outlined above tell the story of what auto dealers have been experiencing for months now. Tight supply unable to keep up with demand are leading to a red hot market, and it looks like price and turnover metrics may continue to reach new heights until supply issues are alleviated.Pickup Truck Market Share StumblesOne effect that these current market conditions have had on the automotive industry involves sales of pickup trucks. According to Wards Intelligence, large-pickup truck market share was 13% of total sales in July 2021, down from 15.2% in July 2020. This was the lowest market share figure for the vehicle class since July 2016. In April of this year, Ford decided to prolong its production shutdown for the F-150 pickup truck, citing parts shortages as the primary cause. During this period of shutdown for Ford, General Motors pressed forward with its production of the GMC Sierra, mentioning the importance of its pickup truck sales to the firm’s bottom line. Ford was able to restart truckproduction in June, but the decision by General Motors to sink available resources into its truck models eventually resulted in its own forced production shutdown in late July.Stories like these have dominated automotive news cycles over the last several months and it is not hard to believe that, despite the importance of pickups to the profitability of these firms, trucks are equally as hard to produce during this period of input shortages as other vehicle classes, particularly for the larger trucks as compared to other trucks and crossovers. Manufacturers are having to make decisions regarding which models to prioritize, and it seems like start-stop production has already become normal for most manufacturing plants around the country. Manufacturers are expected to continue to intermittently shut down truck production until automotive supply chains recover, while production of other best sellers are prioritized for weeks at a time.With a more complete understanding of the lumpy nature of model-specific production during the last several months, it can be expected to see large swings in market share for under-produced vehicle classes. Shutdowns in April and May related to the F-150 and shutdowns in July and August for the GMC Sierra have resulted in fewer trucks hitting lots, and therefore less market share in the sale of all vehicles for an underrepresented truck class. For the ones that are sold, many may not even see lots as pre-selling has become increasingly important. Once the dust settles and the necessary inputs for vehicle production become more readily available, the market share for pickups is expected to normalize at historical levels or even expand in response to pent-up demand. Until then, expect volatility in metrics like market share going forward.What To Expect? ForecastOver the last three months, many experts have tried to predict vehicle production rates to no avail. Mercer Capital’s own December 2020 Forecastfor the 2021 SAAR was in the range of 16 million units, quite bullish at the time. Looking forward to the end of supply shortages and heightened demand has proven a difficult task, and many previously bullish analysts are rolling back their expectations for a third quarter rebound. For example, the LMC Automotive forecast was reduced by 200,000 units on its last iteration. With more frequent announcements on manufacturing stoppages hitting the presses each week, the industry should not expect inventory levels to change much over the next month. With this in mind, total light vehicle sales are still expected to be around 16.5 million unitsin 2021.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

First Half 2021 Review of the Auto Dealer Industry

What Are Key Statistics Saying?

As we enter into the second half of 2021, first half statistics are being released and second quarter earnings calls are on the horizon for the public auto companies. We’ve all read the headlines of the auto dealer industry in 2021: heightened profitability, historic gross profits per unit and soaring retail sales prices for new and used vehicles, and inventory shortages and challenges caused by plant shutdowns and the microchip shortage. What are some of the key statistics saying about the current and future health of the auto dealer industry? Have they peaked, are they continuing to increase or beginning to decline, and/or how long will the current conditions hold?Back in December, we analyzed the state of the auto dealer industry through the use of various statistics/metrics: Retail Gross Profit Per Unit – New Vehicles, Retail Gross Profit Per Unit – Used Vehicles, and Used to New Vehicle Sales Unit Ratio. In this post, we revisit and examine those statistics through the first half of 2021 and discuss other key statistics including Average Days’ Supply, Fleet Sales, and Vehicle Miles Traveled.According to Dealership Profiles reported by NADA, average dealerships have posted pre-tax earnings at 5.1% of revenues as of May 2021 (most recently published data at the timing of this post). This figure has climbed through the start of 2021 and is higher than any reported annual figure since 2010, (when the NADA began publishing the data). How long can this continue and what are the key drivers of the historic profitability?New VehiclesThe sale of new vehicles continue to be impacted by imbalances between supply and demand. While auto dealers are selling fewer new vehicles, the average selling price and the retail gross profit per unit ("GPU") are at all-time highs.Let’s revisit retail gross profit per new vehicle: the numerator is gross profit achieved on the retail sale of new vehicles (as measured by the retail selling price less the cost paid to the manufacturer to acquire the vehicle) and the denominator is the total number of new vehicles retailed (fleet sales are excluded).As seen in the graphic below, the new vehicle GPU rose throughout late 2020 and has continued that rise through May 2021, to a total of $3,139 per unit. New vehicle GPU has risen every month in 2021, but will/can it continue? To answer that question, let’s start with the average days’ supply of the new vehicle equation. Average days’ supply is a metric used to measure the amount/supply of new vehicles that either an auto dealership or the auto dealer industry as a whole holds in relation to the average daily demand. The ratio is calculated by first determining the average monthly daily units of new vehicles by taking the prior month’s or average month’s unit sales divided by 30 days to arrive at average daily units. Finally, the number of new units in inventory at any given point in time is divided by the average daily units to determine the average days’ supply. This ratio is tracked on both new vehicles and used vehicles. Historically, the auto industry operated at an average days’ supply for new vehicles around 60 days. Average days’ supply on new inventory continues to plummet in 2021, reaching a low of 25 days’ supply as of June 2021. At the two state auto conventions that we attended last month, every auto dealer that we spoke with reiterated these conditions. It was very common to hear dealers state inventory unit numbers in the single digits for most of their franchise’s best models. Industry experts are predicting that July numbers will continue to follow these trends. July sales are expected to decline due to a lack of inventory, putting downward pressure on both the numerator and denominator. If the average days’ supply for new vehicles continues to fall, that means supply is falling faster than demand. Some early highlights from the Q2 earnings calls from the public auto companies indicate that they are experiencing average days’ supply less than 20 days and in some extreme cases, less than 10 days. New vehicle production and inventories are not anticipated to stabilize until the latter part of 2021 or perhaps not until 2022. In the next few months, the lack of supply will eventually cut into the heightened profitability that auto dealers have experienced for the first half of 2021. Even if GPUs are high, eventually such a decline in volume will necessitate a decline in overall gross profit levels, even if margins remain solid. It will be interesting to see how the OEMs respond to new vehicle production and average days’ supply when plants and conditions return to normal. The industry has proven it can operate more efficiently at leaner levels of inventory, but will the OEMs return production to the historical levels of 60 average days’ supply? While profits are higher, consumers are unlikely to be as understanding to the lack of inventory after the difficulty of reopening post-pandemic is solved. Used VehiclesLike new vehicles, used vehicles have also been impacted by supply and demand. Demand for used vehicles has increased rapidly due to shortages of new vehicle inventory and also changing consumer preference for those impacted financially by the pandemic.According to Cox Automotive, the average retail price of a used vehicle climbed to an all-time high above $25,000 for June 2021. As a result, auto dealers are experiencing record highs for retail gross profit per used vehicle.GPU for used vehicles is calculated the same as new vehicles discussed earlier, just for used vehicles. As seen in the graphic below, the used vehicle GPU rose in late 2020 and continued to rise through May 2021, to a total of $3,275 per unit. Used vehicle GPU has also risen every month in 2021, but will/can it continue? To answer, we again turn to average days’ supply. According to data published by Cox Automotive, the average days’ supply of used vehicles ranged between 55-66 as seen by actual data from November 2019 (pre-pandemic) and December 2020 (during the pandemic). Average days’ supply on used inventory has shown signs of improvement from a low of 33 units in March 2021. June 2021 levels have risen to 41 days supply as seen below. The bigger impact for auto dealers continues to revolve around sourcing for used vehicle units. Historically, auto dealers have sourced used vehicles from trade-ins, purchasing wholesale units at auction, buying back rental car fleets, and purchasing off-lease vehicles. With fewer new vehicle sales, there are fewer trade-ins. Sourcing vehicles at auction can be tricky for auto dealers in a market where used vehicle prices are at all-time highs and will likely revert back to normal at some point. Dealers must be cautious not to purchase large amounts of used vehicles at these elevated prices for the fear that they won’t be able to sell all of those units before prices return to more normal levels. As we will discuss later, the number of used vehicles available from rental car fleets has been drastically reduced from historical levels. Finally, there are fewer off-lease vehicles available for repurchase as customers are choosing to purchase those vehicles outright once the lease term ends. As discussed in our December post, the ratio of used vehicles to new vehicles sold approached 1:1 as dealers experienced heightened GPUs on both sides. That ratio continued to climb in the early part of 2021 topping out at 98.2% in January but has declined slightly to 87.5% in May 2021. Historically, the gap between GPU earned on used vehicles to new vehicles was wider than it has been in recent months. Now auto dealers are seeing margins nearly as high on new vehicles. This ratio continues to be impacted by shortages in inventory supply, increased retail prices, and uncertainty of financial constraints caused by the pandemic. We can think of two potential demand-related reasons GPUs earned by dealers on new vehicles are catching up to used vehicles. Surging auto prices have made it into the headlines; consumers continuing to shop likely have some level of inelastic demand and if they have to pay heightened prices, they may as well pay a little more to get a new vehicle. Also, with the “K-shaped recovery” we’ve seen during the pandemic, it’s possible those with more disposable income, who may be more likely to buy a new vehicle than a used vehicle, are composing a greater percentage of buyers, tilting demand and thus profits, towards new. Fleet SalesFleet sales consist of sales to large rental car companies, commercial users and government agencies.Historically, fleet sales allowed auto dealers to sell surplus inventory and to sell larger blocks of units at one time. While fleet sales typically occurred at reduced margins compared to retail sales, they allowed auto dealers to put more vehicles in service to hopefully benefit the fixed operations of an auto dealer as those vehicles will eventually require service maintenance and parts. Auto dealers anticipate that buyers of new vehicles will continue to return to the same dealership for those services during the lifetime of the warranty period and hopefully beyond.During the height of the pandemic, fleet sales declined significantly. Rental car companies weren’t just canceling orders, they actively sold off their existing fleet to build up cash as cities endured temporary shutdowns and much of domestic travel was halted or significantly curbed. While travel has returned in the second quarter of 2021, overall fleet sales remain depressed.As discussed earlier, auto dealers no longer have excess inventory, and so OEMs are prioritizing all the vehicles they can produce to be sold at heightened retail prices and gross profit margins to individuals.Fleet sales for the first half of the year totaled 969,751 units according to Cox Automotive. This figure represents an increase of nearly 5% compared to the same period in 2020 as demand has increased. However, comparisons to 2020 are not as meaningful due to the interruptions in the auto dealer industry caused by the pandemic. For a truer comparison, 2021 fleet sales represent a decline of over 40% from the same six month period in 2019 as seen below. So far, auto dealers have not been fazed by the lack of fleet sales. Perhaps the biggest impact of fleet sales has been felt by consumers. If anyone has traveled recently and tried to obtain a rental car, you likely have experienced an overall lack of supply and a dramatic increase in rental car prices. The impact felt by the fleet market on auto dealers has been on the used vehicle side of operations. While rental car companies sold off large portions of their fleets in 2020 with the lack of travel, they have not been able to replace that inventory as travel demands have increased. In turn, rental car companies are currently no longer a source of used vehicle units for auto dealers since those purchases were pulled forward in 2020. It will be interesting to see how these conditions evolve over the latter half of 2021 and 2o22 as manufacturing begins to return to normal from the OEMs. Vehicle Miles TraveledAnother key indicator that portrays the health of the automotive industry is the number of miles driven or vehicle miles traveled ("VMT"). As with the number of vehicles in service, the number of miles driven contributes to the fixed operations of an auto dealer as vehicles require more parts and service as they are driven more frequently or for longer distances. Increased miles will also lead to the eventual purchase of a new vehicle either from new or used vehicle inventory.VMT has been tracked since 1971, and a graphical view of the rolling 12-month average can be seen below.Over time, VMT has generally increased as the population has grown and more vehicles have been put in service. Since 1971, there have only been a few occasions where the rolling-12 month average has declined, which as noted above, tend to correlate with recessions: 1974, brief periods in the late 1970s and the early 1980s, the Great Recession in 2008 and 2009, and the pandemic in 2020.During the height of the pandemic, the rolling-12 month VMT average dropped below 3 trillion miles for the first time since mid-2014 and even below 2.8 trillion for the first time since the early 2000s. The rolling-12 month average bottomed out in February 2021 at approximately 2.77 trillion miles and has steadily climbed back up to 2.97 trillion miles as of May 2021.During the pandemic, a report from KPMG highlighted some of the factors impacting the VMT and also hinted at longer-term trends that could eventually push that figure back up to historical levels. Obvious factors from COVID-19 included temporary stay-at-home orders and restricted travel. As the pandemic continued, work and commute habits also changed as more individuals either worked from home initially, or others have continued to work from home in some capacity. These behaviors drastically contributed to fewer and shorter work commutes. An additional factor impacting VMT was fewer shopping trips. Digital platforms and e-commerce continue to grab market share from traditional shopping trips to the store. This phenomenon was already occurring prior to the pandemic but continues to persist as some consumer behaviors may have been permanently altered due to long-term health and safety concerns.Is it all bad news as far as VMT is concerned? As mentioned above, the rolling-12 month average has been steadily climbing since January 2021. Shutdowns and stay-at-home orders have all mostly expired and there is pent-up demand in domestic travel.As a result of the pandemic, more people could eventually decide to move out of larger metropolis areas into smaller suburbs. Moving out of the city could create longer commute times and miles driven. Additionally, people may continue to avoid public transportation and rideshare services due to the health impact scares of the pandemic. Both of these trends could lead to more individuals purchasing vehicles, which would eventually contribute to more miles driven.Conclusions The first half of 2021 has been a memorable one for auto dealers highlighted by all-time profitability, heightened gross margins on new and used vehicles, and shortages of new and used inventory. How long will these trends continue and have some trends already shown reversion back to normal levels?As we’ve discussed, certain metrics such as gross margins per unit continue to rise, while others such as average days’ supply of used vehicles, overall auto sales, and vehicle miles traveled appear to be trending toward historical levels. Industry experts are mixed on predicting when inventory conditions stabilize; some indicate later this year, while others indicate it could be 2022 before inventory/supply issues return to normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst the noise, contact a professional at Mercer Capital to perform a valuation or analysis.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents. Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information. For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods. Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric. These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business. This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets. No long division required.This can also lead to less contentious transfers if everything goes smoothly. If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly. However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

June 2021 SAAR

The June 2021 SAAR totaled 15.4 million units, which is up 12.4% compared to June 2020 (the lowest June figure in recent memory due to the COVID-19 pandemic) but down 9.9% from May 2021. New light vehicles sales fell for the second straight month in June, highlighting the ongoing supply and demand imbalances in the market for new cars and trucks.After a strong start to the year, driven by feverish demand from retail and fleet consumers, a shortage of new car and truck inventory has started to weigh on sales. The Inventory to Sales Ratio, published along with SAAR, continues to fall, as seen in the graph below. This ratio captures what many auto dealers already know: demand has been strong and supply chain issues have not gotten any better. With such strong demand intersecting low supply, many vehicles are selling at or above MSRP. According to J.D. Power, in mid-June, 75% of vehicles sold for MSRP or above, up from 67% in May 2021 and up even more from the pre-COVID-19 pandemic average of 36%. SAAR ran hot from 17.0 million to 18.6 million from March to May this year, making supply even shorter. Inventories have plummeted as dealers are not able to replenish their lots. While this has led to lower floor-plan costs and higher GPUs, the decline in SAAR in June shows dealers may finally be experiencing what people were concerned about. Business owners can draw down inventories to maintain sales levels, but eventually, those inventories will run out. Lower inventory levels are expected to continue to limit the sales pace of dealers around the country. Microchip Issues PersistAccording to the NADA, the inventory crunch is likely to get worse before it gets better. Average inventories are expected to remain flat in June compared to May at around 1.5 million units, before dropping again to around 1.3 million units by the end of July. Microchip shortages continue to plague the industry and are a predominant factor in the slowdown, though dealers have noted other parts and areas of vehicles are in short supply as well. With little to mitigate the situation on the horizon, it has become clear that this shortage will impact the manufacturing of new vehicles for months to come. This chip shortage is not unique to the United States or to the Automotive industry, as Automotive News Europe recently reported that the “exponential increase in demand for microchips will need a long term solution.”We note the “end” to the microchip shortage continues to be kicked down the roadMany sovereign governments are considering taking steps to increase production, as the number of industries that require microchips continues to grow. Economic agents are considering economy-wide solutions to this sweeping problem, but relief is not expected until sometime in early 2022. Until then, dealers will most likely have to continue to operate at lower-than-normal inventory levels or focus on vehicles that utilize less chips. We note the “end” to this shortage continues to be kicked down the road, so even the expectation this situation will be alleviated in early 2022 may not comfort dealers that have seen expectations continue to get pushed out.Several U.S. automotive manufacturing plants have had to suspend operations in response to the chip shortage. For example, the Ford plant in Chicago that produces the Ford Explorer will be shut down from the week of July 5th to the week of July 26th. Additionally, the Ford plant in Kansas City that produces the best-selling F-150 pickup truck announced it will be shuttering the production line for a few weeks in July as well. Ford’s Michigan assembly plant that recently started shipping the Ford Bronco will also be down for two weeks in July due to parts shortages. These shutdowns are not specific to Ford, as most auto manufacturers have been trying to find ways to react to the ongoing situation.It’s Not Just Microchips Many automotive plants have temporarily shut down due to the microchip shortage, but microchips are not the only input that has been scarce. Seating foam, plastics, and other petroleum-based products have been harder to acquire over the last several months due to longer lead times on orders, historically high prices, and very tight supplies.According to Industrial Specialties Manufacturing, the market is currently unable to supply the U.S. demand for plastics. Experts say that the complete restoration of the plastics industry could come in late 2021 or early 2022, but certain factors must be in play for this recovery to occur, like repairing oil and gas infrastructure, returning to normal volumes of chemical feedstock for plastics production, and repairing plastics compounding and extruding machinery in plants that have yet to ramp up to full production capacity.Used Vehicles In High DemandWhile the story surrounding new cars and trucks has been characterized by supply constraints over the last two months, used cars have stepped into a more prominent role at most car lots to fill this gap. Pent up demand for new cars is pushing car buyers into the used-car market, driving up prices of used cars in the process. Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last year, the highest price jump on record for the auto research firm. This has had ripple effects throughout the economy.Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last yearThe Consumer Price Index jumped 5.4% in June, stoking concerns about runaway inflation. However, the Federal Reserve has maintained its view that inflation is transitory, which appears to be supported by the significant year-over-year increases in used vehicles, gas, and airfare, which have played a large role in the jump in CPI. Excluding these, month-over-month core CPI would have only risen by 0.18% in June according to Bank of America.Used vehicle prices have climbed at a steep pace due to similar supply and demand-related pressures as the new car market, with scarcity issues coming in the form of hotly contested wholesale markets where dealers typically acquire most of their used inventory. Dealers are being forced to spend more to fill their lots with used vehicles, making it harder for buyers to negotiate on used car prices than in the past. Jonathan Banks, Vice President of Valuation Services at J.D Power had this to say about the used market:"After increasing for 24 consecutive weeks, wholesale auction prices peaked in June, attaining their highest level on record, and have now begun to gradually decline. Despite the recent cooling, the used market remains incredibly strong and, at the end this year, prices are expected to be up by approximately 29% on a year-over-year basis. The used market’s continued strength is driven primarily by the expectation that used supply will remain a challenge and that new-vehicle market challenges will remain in place for the foreseeable future."What Forecast to ExpectAfter an unusually hot start followed by a tightened market environment, this year has been unpredictable for dealers and manufacturers in the automotive industry. As far as demand is concerned, it is unlikely that the desire for new and used vehicles will cool off any time soon, as many consumers return to work and may be in search of a new or used vehicle to get them there. However, new light vehicle sales for the remainder of the year will likely continue to be supply-constrained. If production can recover and exceed expectations, we could see sales close to 17 million units by the end of the year. However, given the more likely outcome, total light vehicle sales are expected to be somewhere between 16.3 and 16.5 million units in 2021.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

The Electric Vehicle Race

Tesla vs. Everyone

Is Tesla’s Grip On the EV Market as Iron Clad as It Once Seemed?Electric vehicles have continued to gain momentum, forecasted to reach 3.55% of the U.S. market share of total vehicles by the end of this year. While this is still a relatively small portion of total auto sales, manufacturers continue to invest in their electric technology to prepare for a future in which electric vehicles may be the norm. When you think “electric vehicles,” there has been one brand that has established itself as a clear leader: Tesla. Elon Musk, Tesla CEO, when he’s not tweeting about Dogecoin or other memes, is solidifying the company as the go-to manufacturer for electric vehicles. According to data from Experian, Tesla accounted for 79%of U.S. EV registrations in 2020, with 200,561 of its electric battery operated vehicles registered. This is an increase of 16% from 2019 when owners registered 172,438 Teslas. Tesla has dominated the industry, with the three highest selling EV models since 2018 as seen in the graph below. Tesla’s Model 3 alone has more sales than all the other electric vehicles combined and when you consider the Model S and the Model X, there have been three times more Tesla vehicles sold than the trailing top 5 competitors. While Tesla’s dominance in the U.S. is clear, the graph below helps illustrate that Tesla’s lead may not be as iron clad as it once was when looking at market share on a year-to-year basis. Tesla’s Model 3 has been losing market share since 2019, largely attributable to the influx of new EV options in the marketplace. In 2021, Model 3 market share is anticipated to drop even further, with expected new EV options diluting the market. With more auto groups intent on gaining a slice of the pie, competition is expected to continue to steepen going forward. CompetitorsWho is challenging Tesla in the EV space? We have laid out the top competitors:VolkswagenAfter half a million diesel Volkswagen models were cited for violations in the 2014 emissions scandal, the company is clearly trying to clean up its image. One way they are doing this is in electric vehicle initiatives. In 2020, the brand delivered nearly three times as many pure-electric vehicles as they did the year before, up to 134,000 electric vehicles and 212,000 electrified cars in total worldwide. By 2030, the company hopes that their fully-electric vehicles will account for more than 70% of the brand’s European sales and a market share of over 50% in U.S. and China.Deutsche Bank analysts have bullish predictions for Volkswagen. As a team of analysts led by Tim Rokossa noted that with a new target for electric vehicles of 1 million this year, the majority of which will be electric battery vehicles, the German automobile maker should come “very close to Tesla’s battery electric vehicle sales.” Volkswagen is already taking a lead in European markets, as they accounted for more than 22%of the market shares after 10,193 vehicles were registered. This compares to Tesla’s market share in 2020 of only 13% across the pond. Looking forward, Volkswagen’s ability to convert customers in the U.S. market will be crucial in gaining market share.StellantisLike Volkswagen, Stellantis presents a substantial threat to Tesla’s electric vehicle dominance in the United States after it has performed impressively in Europe. The world’s fourth largest car maker’s electric vehicle share accounts for nearly 17% of the market share in Europe, trailing only Volkswagen. The company announced last Thursday that it would invest more than $36 billion through 2025 as a plan to accelerate in the EV race. The company had already announced in April that they set out targets to offer an electrified version of nearly 100% of its models by 2025. With this investment initiative is the bold plan of targeting 70% of European sales and 40% of U.S. sales coming from low emission vehicles by 2030. The company has significant ground to make up in the U.S. markets in order to achieve this goal, and like Volkswagen, will need to focus efforts on conversion in this market.FordFord’s sales of EVs expanded 117% in June, reaching a new first half sales record of 56,570 vehicles. Behind these figures were the success of Ford’s fully electric Mustang Mach-E and F-150 PowerBoost Hybrid. More importantly than just the recent increase is the fact that 70% of customers who bought the battery electric SUVs are new to Ford, meaning the additions may be helping them to capture market share.Ford’s ability to produce an electric pick-up, the F-150 Lightning Electric truck, makes them dangerous in a U.S. auto market driven by light truck sales (light trucks accounted for 75.9%share of U.S. auto sales in 2020). With Ford having thesecond largest total vehicle market share in the U.S., trailing only GM, their ability to convert current users of their traditional vehicles to electric will be just as important as gaining new customers in expanding their EV market share reach.General MotorsThe largest auto manufacturer of traditional vehicles in the U.S. is hoping to have success in the EV space as well. The Chevy Bolt has the highest number of sales in the U.S. of non-Tesla brand vehicles. Additionally the company has committed to becoming an all-electric vehicle company by 2035, meaning there is significant investment in this business line that is occurring. The company is also hoping to cut costs through making their own battery cells through a joint venture with LG Chem in Ohio. A facility is under construction and expected to be completed by 2022. Like Ford, a key component in gaining electric vehicle market share will be converting some of their current users of traditional vehicles.Batteries Are KeyDespite the encroachment of other traditional OEMs on Tesla in the EV space, the hurdle that they will have to overcome to catch up lies in one specific part of the vehicle: the battery. It is currently a race to the bottom, with the battery costs in an electric vehicle being a primary reason that electric vehicles continue to be pricier more costly than traditional vehicles. However, this price has been dropping, with Tesla leading the way. Tesla has managed to drop their cylindrical cell battery pack down to around $150 per kWh last year, nearly an 87% decline from 2010 as seen in the graph below: Tesla is the only automaker to use this type of cylindrical battery cells in its battery pack. Its competitors, like those discussed above, use battery packs containing pouch or prismatic battery cells. According to Cairn, these cost on average more than $200per kWh in 2019. Automakers are aware that even though they are throwing billions of dollars at batteries and EV production, Tesla’s lead on the technology of these vehicles is undeniable. Colin Rusch, auto analyst for Oppenheimer notes, “At core there is really incredible battery technology within the organization and that is material science that they have been working on for well over a decade. We think they have some substantial advantages on that.” Tesla competitors eager to get the edge on the EV giant will have to continue to invest in their battery technology in order to drive down prices. The Real WinnersThough uncertainty remains surrounding whether or not Tesla will be dethroned in the U.S. EV space, there is one clear winner among all of this investment and competition: the consumer. More investment into EV technology and competition between brands means that electric vehicles likely will become more readily available to car buyers at more affordable prices. While Tesla is the largest player in the U.S. market, their image of luxury vehicles prevents many people interested in electric from joining the market. Larger offerings of mass market vehicles will help to show the true demand that is there for these types of cars and trucks.Additionally, auto dealerships also stand to benefit from this push. With two thirds of car consumers interested in electric vehicles, they may present a unique opportunity for dealerships particular those whose OEM is able to produce the most attractive models. However, there are some concerns about how EV’s will affect the bottom line on the service portions of the business. A 2019 reportfrom AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell. If electric vehicles ultimately gain the market share that they are anticipated to, dealerships may need to become more savvy in mitigating these service and parts revenue declines. Like NADA, we remain bullish on the role of auto dealerships in the EV sales process despite concerns regarding direct-to-consumer sales channels from the OEMs. Additionally, dealership owners have expressed some concern over how OEMs will handle the EV units from their traditional dealership models. If OEMs continue to allocate units to each dealership, this presents an opportunity. However, if they instead follow Tesla’s lead and adopt a more direct to market approach to selling new units, this may pose a problem for dealerships.If you would like to know more about the electric vehicle industry and what this all may mean for your auto dealership, feel free to reach out to anyone on Mercer Capital’s Auto Team.

Industry Trends From the Road

Key Takeaways from State Automotive Annual Conventions

We recently attended the annual conventions of two state automotive groups – Kentucky and the Tri-State Convention consisting of Tennessee, Alabama, and Mississippi. It was refreshing to attend live events again after the virtual world we have all grown accustomed to over the last fifteen months. Live events like these serve as a great venue for shared information about industry trends and cultivating business relationships.In this post, we summarize certain sessions that our readers might find of interest. If the topics were similar, we present those topics together. We also layer in highlights from our conversations with dealers and other industry participants.Cybersecurity for Auto Dealerships and Fraud and the Distracted EmployeeCybersecurity IssuesOver the last year, there have been several high-profile instances of cybercrimes and fraud, including the ransomware hacks on Colonial Pipeline and JBS. These topics that typically lurk in the shadows have been brought into the national discourse, and there were two sessions devoted to best practices to protect against cybercriminals and how to detect fraud from within an organization.While we typically think of these sorts of things as something that happens to other people, speakers showed just how much they can impact the auto dealer industry and how the economic fallout of the COVID-19 pandemic has increased the motivation and prevalence of fraud.Auto dealers experience nearly six times the amount of cyber criminal activity than other industriesIdentity Theft crimes account for $50 billion in damages and recovery expense annuallyOne of the most common methods for committing a cybercrime in auto dealers is through the use of business emailOne of the most common methods for committing a cybercrime in auto dealers is through the use of business email. Key management and particular controllers, payroll managers, and accounts payable clerks should pay special attention to the spelling of names in emails received and also the domain name portion of the address. The strongest defenses against compromises in cyber crimes attempted through business emails are the following:Strong Password – have unique and lengthy passwords for all of your various accountsTwo-Factor AuthenticationTelephone confirmation for fund transfers before wiringBeware of unexpected urgency – Phishing emails prey on the urgency of the situation they create by saying that funds must be wired within a short amount of time to guilt the recipient into immediate actionCyber Security Training – Create a culture of training and accountability for your staff. Create a message from the top that permeates throughout your dealershipHow to Understand and Protect Your Dealership from FraudUnfortunately, these threats are not exclusively external threats. Too often internal and trusted employees can be the culprits. Auto dealers should consider the following statistics.Over 50% of companies have been victims of embezzlement by their own employeesTypical organizations lose 5% of their top line revenue to fraudOver 50% of employees committing fraud have been with the company over five yearsMedian length of time to detect fraud is 18 months58% of fraud cases have no recovery at allAnonymous tip lines are one of the greatest ways to detect fraud because someone within the organization is probably aware of what is going on If fraud is occurring in your dealership and it is most likely being committed by longer tenured employees. What behaviors should you be observing as possible red flags?Employees living above their means, or the opposite, experiencing financial difficultiesEmployees that are unwilling to share their duties with other members of the organization and/or rarely take time offEmployees who have recently divorced or are experiencing other family problemsEmployees that have an unusually close relationship with a particular vendorKey TakeawaysAuto dealers should communicate to their employees the potential damage to the business from a ransomware attack or other similar threats. This includes training employees on what these schemes look like and creating a culture to protect against external and internal threats. Auto dealers must confront conflicting agendas to protect their dealerships: while you want to empower your employees to do their jobs well and trust them without micromanaging, it’s also important to not be too detached and “inspect what you expect” might be potential fraud. Finding that balance is critical. A three-pronged approach to internal fraud is key: deter, detect and prevent.How can auto dealers put this approach into practice? Set up internal controls so that one employee isn’t responsible for all elements of transactions. Segregate duties among various employees. Rotate functions so that the same person doesn’t handle the same aspect of the business at all times. Besides being good practice against fraud, this also reduces systemic risk of the dealership that we in the valuation world discuss as a “key person risk.” Businesses whose operations are not specifically reliant on one person tend to be less risky and therefore more valuable. While typically this is thought of as the dealer principal or upper level management, it’s important to have these considerations throughout your organization.The Dealership of Tomorrow and Regulatory Items in the Biden EraFuture Trends and Their Possible ImpactThe pandemic had an acute economic impact on many Americans, and it accelerated many trends from before 2020. One of our speakers took a long view at these trends and offered his view of the future of traditional auto dealers.Then, we look at recent trends in the industry from a more regulatory point of view. When the White House administration changes, particularly to a different party, there is likely to be change to regulations at the federal level, particularly considering Biden was a part of the administration that preceded his predecessor. How will these changes impact dealerships?Despite the ebbs and flows of trends that come and go, dealerships have utilized all of their profit centers to their advantage, so when one area of the business is declining, another is likely benefiting. Even through challenges such as electric vehicles, autonomous vehicles, rideshare, and connected cars, the industry has proven it can adapt and remain viable.No country in the world exclusively utilizes a direct sales model for retail automotive salesWhen it comes to electric vehicles, speakers at our conferences offered some rebuttals to some prevailing arguments, particularly those proffered by proponents of direct to consumer sales. No country in the world exclusively utilizes a direct sales model for retail automotive sales. While some upstarts like Tesla have adopted that model, all countries still maintain and utilize some OEM/dealership model. While direct sales proponents insinuate that franchise laws are the only thing preventing a shift in the market, countries without these laws do business very similarly. If EVs are going to be successful, it will likely be dealers who have made the investment in personal relationships in their community who can help consumers understand the benefits and challenges of the new technology.There has been plenty of talk around the topic of consolidation in the industry, but the total number of automobile dealerships or stores has only declined approximately 1.9% from 1970 through 2019. There are approximately 18,000 stores in the U.S., and it looks like this number may stay relatively consistent.In the past decade, the number of owners has declined from 10,000 to 7,500. Despite the challenges related to the pandemic, the auto dealer industry only lost 31 dealers in 2020, or ~0.2%. While some dealers may capitalize on heightened valuations and exit with more Blue Sky value, there’s a sense that the total number of rooftops nationwide won’t similarly decline. Despite the recent uptick in investment by the public auto dealers, their share of the entire automotive market is less than 10% by location. If Lithia and others continue to acquire and Blue Sky values stay high, this could change. However, years of evidence does not seem to clearly indicate that public dealers necessarily can operate more efficiently than their privately held counterparts.Will OEMs exercise restraint with their facilities and imaging requirements? The buying experience for consumers and their preferences shifted during the pandemic. Shutdowns and health fears led to more investment in the digital/online channels for vehicle retail sales. With dealers seeing less foot traffic at their dealership locations, will they want to downsize their facilities, or will the OEMs continue to require continuous upgrades and imaging requirements? Trends surrounding facilities that could evolve after the pandemic include unbundling facilities (i.e., sales and service operations not being conjoined on the same property), placing greater importance on convenience and flexibility.From a regulatory standpoint, there appear to be more threats than opportunitiesPossible RegulationFrom a regulatory standpoint, there appear to be more threats than opportunities:Trade can be an area of opportunity now with the removal of 25% tariffs, but dealers should be aware of how the USMCA, which replaced NAFTA, may impact themLabor constraints have made operations more difficult across all industries, but the speaker pointed to the classification between W-2 employees and independent contractors as a regulatory issue to watchFuel economy standards have changed depending on the current administration, which can make it hard for OEMs and dealers to make long-term plans when the goals for 2035 and beyond continue to be a moving target. Hopefully for dealers, these requirements will be tied to economic viability50-60% of dealers report on LIFO, which is beneficial when inventory levels and/or values are increasing. When volumes dropped during the pandemic (which have been extended by the chip shortages), LIFO dealers are stuck recognizing income, which is unlikely to be changed despite NADA lobbying effortsF&I has increasingly become a profit source, with dealers recognizing more and more of overall profit from F&I rather than the sale of the actual vehicle itself. Will that lead to concerns from the Consumer Financial Protection Bureau that dealers are in effect selling products with interest rates too high, or is this just semantics of how profit is allocated?Key TakeawaysWhile the external alternatives to traditional automobiles continue to arise and the imaging requirements may change in the future, traditional auto dealerships appear to be stable and on solid footing for years to come. Auto dealers should become active and stay in communication with their state associations and politicians to ensure their best interests are being protected during periods of regulatory changes.Succession PlanningGeneral succession planning forces individuals to confront uncomfortable topics including their personal financial circumstances and needs, circumstances and feelings of other family members, and circumstances of the business, age, and quality of key managers/employees. Auto dealers face additional decisions contemplating the OEM requirements for their children or other family members to become a dealer and what will be required for them to become a successful dealer. The approval of a second generation or other family member as a dealer principal is not guaranteed by the OEM. We have encountered this situation at the untimely death of a dealer principal.A critical element of succession planning is determining the value of the business to implement the particular action stepsOne of our speakers demonstrated the difference between “having a plan” and succession planning. Having a plan is more like the noun, or the passive part of the process. Succession planning is the verb, or the active part of the process.A plan can consist of a Buy-Sell Agreement. The success of the process is to live by the terms of the Buy-Sell Agreement or plan and make it a living document rather than have it become a static document that resides in a file cabinet. A Buy-Sell Agreement may appear stronger if it includes a mechanism for the pricing of a dealership that accounts for its Blue Sky value. However, if the document simply indicates a static multiple (say 5.0x, for example) from when the document is drafted, it may not capture how the dealership and the market for dealerships change over time.Key Takeaway: At the risk of appearing self-serving, we offer this truth: a critical element of succession planning is determining the value of the business to implement the particular action steps. Mercer Capital assists auto dealers around the country by performing business valuations to assist with succession planning and wealth transfers. Do you have a plan or have you engaged in succession planning with a financial advisor?ConclusionWe’re glad to be back attending in-person conferences and talking with dealers in person. This leads to a better exchange of ideas on current trends and best practices. If you would like to discuss any of information in this post and how your dealership might be impacted, please contact any of the members of the Mercer Capital auto team.Sources“Cybersecurity for Auto Dealerships,” John Iannerelli, former FBI Special Agent – KADA Convention“Fraud and the Distracted Employee,” Lori Harvey, CISA, CISM, PCI QSA, DHG – Tri-State Conference“Dealership of Tomorrow,” Glenn Mercer, Glenn Mercer Automotive – KADA Convention“Regulatory Items in the Biden Era,” Paul D. Metrey, NADA – Tri-State Conference“Plan Now or You Could Lose Everything,” Loyd H. Rawls, Rawls Group – KADA Conference

Whitepaper: Understand the Value of Your Auto Dealership

If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.Editor's Note: This whitepaper was originally published in August 2020. WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper

May 2021 SAAR

After three straight months of impressive gains, the SAAR fell 9.6% in May from 18.8 million units to 17.0 million units. The summer is typically a strong season for auto sales, but several supply-side factors have limited the availability of vehicles over the last month.May 2020 SAAR (12.1 million units) is a poor comparison to this year’s rate, as the pandemic’s impact was still sending shock waves through the industry at that time. In comparison to May 2019, SAAR is down roughly 2%.The dip in SAAR from April highs should not be viewed in a totally negative light, as many industry experts have spoken to the adaptability and resilience of the industry during a period of record high demand and increasingly less inventory. As seen in the graph below, the inventory to sales ratio has hit record lows as dealers cannot keep inventory on the lots. As noted in JD Power’s Automotive Forecast for May, the average number of days a new vehicle sits on a dealer lot before being sold is on pace to fall to 47 days, down from 95 a year ago. Dealers are also selling a larger portion of vehicles as soon as they arrive in inventory, with 33.4% of vehicles being sold within 10 days of arrival, which is up from 18.2% in May of 2019. Rising vehicle prices continue to reflect this supply and demand imbalance and benefit retailer profits. As reported by JD Power, total aggregate retailer profits from new vehicle sales will be $4.5 billion, the highest ever for the month of May, and up 162% from May 2019. Fleet customers are continuing to suffer as OEMs prioritize deliveries to retail customers over fleet customers. NADA reported that fleet deliveries accounted for just 10% of new-vehicle sales in May, after averaging 16% the first four months of the year. Notably, this was already depressed in 2021 as pre-pandemic levels were closer to 20% of monthly sales. As we noted in our April SAAR, rental cars will continue to be hard to come by. These high prices on rental cars and limited selection will most likely continue until the chip shortage has been straightened out and supply has stabilized. Consumer ReactionsConsumers are having to get creative in order to secure a vehicle. As we mentioned on our April SAAR blog post, manufacturers are hoping that consumers will be flexible and purchase models with less features to save on chips.Consumers seem to be going the extra mile however, with Cars.com finding that nearly 1 in 3 recent buyers drove 100 miles or more to secure the car they want. Kelsey Mays, Cars.com assistance managing editor, noted “With the current auto inventory challenges, recent car buyers are going to great lengths to find the car they want…I don’t anticipate this trend slowing down, either. Of consumers currently in the market and shopping for a car, 65% said they would consider purchasing in another state.”While the extra mileage to find car options presents a clear inconvenience for consumers, they may reap some benefits as well. Over half (53%) of those looking for a new car also plan to trade in their current vehicle to the dealerships. As the inventory shortage has limited the availability of cars on lots, the dealerships are often willing to pay a premium for new inventory. The extent to which consumers are willing to travel to find a car sheds further light on the current supply and demand incongruencies.Government ReactionsThe chip shortage has reached such an extent that the U.S. government is trying to assist. According to Automotive News, the Senate has passed an expansive bill to invest nearly $250 billion in bolstering U.S. manufacturing and technology to meet the economic and strategic challenge from China. More specifically for auto dealers, the bill includes $52 billion in emergency outlays to help domestic manufacturers of semiconductors expand production, which was a bipartisan addition sought by Republican Senators John Cornyn (Texas) and Tom Cotton (Arkansas) and Democrats Mark Kelly (Arizona) and Mark Warner (Virginia). The addition of the semiconductor expansion was cheered by those in the industry who have been struggling to meet demand for months. Though the bill would be welcomed with open arms by the auto dealer industry, its fate is still uncertain as support in the House of Representatives is somewhat unknown. However, Senate Majority Leader Schumer has indicated that he believes the House will be able to get something passed through to President Joe Biden’s desk.When It Will End?With 93%of respondents to a survey conducted by Automotive News about the global chip shortage finding that they believe the chip shortage will have a severe impact on the auto industry, the question on everyone’s mind is when is the end date.While 72% of respondents believe that it will last the rest of the year, Goldman Sachs chief Asia economist Andrew Tilton believes the worst may be over. He has noted that there has been “noticeable tightening” of supply chains and shipment delays in North Asia, which will ultimately have an impact on downstream sectors such as auto production. He and his team believe the chip shortage could improve in the second half of 2021. However, this is a continuously evolving situation as multiple aspects of the supply chain are being disrupted, most recently in Taiwan. Chip manufacturing plants use large amounts of water, and Taiwan, home of the world’s largest contract chipmaker, is facing its worst water shortage in 56 years. This, as well as the continuing COVID-19 pandemic, will need to be monitored closely as the auto dealer industry hopes to move out of this ongoing chip shortage.ForecastWith the chip shortage still in full effect, inventory constraints are going to continue to be an issue through the remainder of the summer. Thomas King, president of the data and analytics division at J.D. Power notes:“Looking forward to June, with sales continuing to outpace production in aggregate, falling inventory levels may start to put pressure on the current sales pace. However, based on what we have seen so far, retailers may continue to adapt by turning inventory more quickly to maintain sales velocity. However, regardless of inventory position, manufacturers and retailers will continue to benefit from strong consumer demand and a higher profit per unit sold.”Through June and the rest of the year, ability to turnover what inventory auto dealers are able to get their hands on will be critical to maintaining profitability levels. Consumer’s willingness to go the extra mile (literally) in order to secure a new car is a positive tailwind, and a continuation of this trend will be beneficial for dealerships. However, the chip shortage continues to need to be monitored closely, though expectations of it easing and government assistance are providing some optimism to the situation.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent. While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets. It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income. As discussed below, there are also other tax planning benefits from this structure. Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent. As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations. If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Valuation and M&A Trends in the Auto Dealer Industry

Full Speed Ahead or Partly Cloudy?

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the release of their Fourth Quarter 2020 Haig Report. Specifically, I wanted to focus on the unique conditions impacting the industry, and also the changing methodology that buyers are utilizing to assess dealership values. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for various auto manufacturers based on their observations and data from participating in transactions in this industry.The Haig Report mentions many buyers are utilizing a three-year average of earnings to calculate the expected performance of the dealership. Why has this new trend occurred and how has a buyer’s pricing methodology shifted in 2020/2021?KN: Prior to the pandemic, the auto retail market had effectively plateaued with sales declining slightly and dealership profitability fairly stable. The roller coaster of 2020 - a lockdown, then a big upswing as pent up demand and stimulus money flowed through the system in the summer, followed by continued retail demand and tight inventories, created a lot of “noise” in dealer financial statements. Even with exclusion of PPP fund impact, overall dealership profitability was incredibly strong with many stores achieving all-time record profits. This created a challenge for buyers as they attempted to identify the correct income to base their buying decisions. When you apply a multiple against expected earnings to determine value, one needs to have confidence the earnings will materialize. Given the volatility in performance, buyers have been reluctant to price a deal solely on 2020 results, making the argument the performance was artificially inflated. Sellers counter by illustrating the strong results were not a summer phenomenon but have continued into 2021 and no end is in sight. Going forward inventory availability remains an issue creating nice margins, interest rates will remain low for the foreseeable future, and expense controls have taken some of the bloat out of the business. As a result, many buyers are using a three-year average (2018-2020) as their earnings baseline. This gives the seller credit for the strong 2020 numbers but reflects expectations that future results will likely settle back to pre-pandemic numbers. Notably, some markets that were harder hit by the pandemic did not generate record numbers, and some buyers are utilizing 2019 as their baseline so as not to punish a seller for a down year in 2020. Regardless, it takes more massaging of past performance to establish a baseline for future results. SW: The methodology described by Kevin compares to our longer-term view of a dealership’s earnings and profitability. A valuation considers the expected ongoing earnings or cash flow of the dealership, and as such, several factors should be considered including historical, current, and expected operations in the future. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year, if neither are sustainable. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Will buyers revert to Trailing 12 Months (TTM) as their baseline or will the three-year average method remain for some time?KN: Adjusted TTM earnings became the primary baseline for applying a multiple because the industry performance had been fairly stable for some time. Yes, there were specific dealerships that had better or worse results, and those were valued with appropriate modifications to forecasted earnings. Given the aforementioned volatility in 2020, the expectations of a strong 2021 and a potential gradual return to pre-pandemic levels, using a three-year average of earnings has become a more accepted strategy. Until we see stability in the automotive retail sector for some time, it’s unlikely TTM will return as the primary earnings metric. Of course, there are always exceptions including unique market dynamics, identified changes to the business or a highly competitive market for a dealership that may require buyers to give more credit for 2020 and 2021 results.Has there been a prior time when a three-year average was the preferred method for calculating earnings and, if so, what were the underlying conditions at the time?KN: Using a three-year average was a fairly standard method until recently but as dealership performance became stable and predictable, both buyers and sellers gradually settled on TTM as an effective proxy to base their valuation. Simplicity and the lack of variance in performance made it an easy calculation and removed some of the tension during negotiations. Of course, there has and will continue to be discussion and debate on add-backs and proforma earnings when strategic shifts at the dealership might yield better results. In general, the more consistent the performance, the more likely the buyer can get comfortable using the most recent financial period to calculate a value. SW: As we discuss on a monthly basis, the auto SAAR (number of lightweight automobiles and trucks sold on an annual basis) is one of the general indicators of the conditions in the industry. To view Kevin’s rationale behind the stability in the industry through the lens of SAAR, SAAR was fairly stable and roughly averaged between 16 and 18 million units from mid-2014 through the first few months of 2020 prior to the pandemic. SAAR collapsed to 11.361 million units in March 2020, before bottoming out at 8.721 million units in April 2020.What other changes or areas of focus are buyers concentrating on given the unique 2020 environment?KN: As buyers look to 2021 and beyond and evaluate how a target might perform going forward, there are certainly some areas of the business that are receiving attention:New vehicle margins – Given industry constraints on production, new inventory levels on dealer lots are quite low, allowing dealers to increase transaction prices and realize stronger margins. This is expected for most of 2021 and possibly into 2022. There is also dialogue that given improved profitability at OEMs, suppliers, and dealers, a more balanced production vs. demand market may continue, maintaining improved margins.Used vehicle margins – The used vehicle market dropped initially during the pandemic lockdown, spiked again, and has remained fairly strong since the fall. Now with new vehicle shortages, we are hearing dealers are driving up acquisition prices on used vehicles. The lack of new availability could drive consumers to used and keep margins strong or the frenzy to buy inventory could lower margins if consumers balk at the higher costs of the vehicle.Fixed operations – Most dealers saw a drop in 2020 fixed operations as the lockdown cost them weeks and months of customers. Given most dealership service bays are at or near capacity, you can’t make the business up. However, the 4Q of 2020 saw fixed revenue return to pre-pandemic levels. Thus, we expect 2021 to show nice growth in fixed operations over a lower 2020 and the past trend of annualized revenue increases should continue in 2022 and beyond.SG&A expenses – Key expense categories including floor plan interest, advertising and personnel saw nice declines in 2020. It is likely interest rates will remain close to zero, possibly into 2023. Many dealers see lower advertising as a continued theme for the foreseeable future given demand is exceeding supply. Finally, as dealers refine their sales and delivery channels and more transactions move online, we hear a number of dealer principals indicate their staffing levels will be permanently lower.SW: Gross profit per unit numbers for new and used vehicles continues to be very strong, with average reported figures for March at $2,764 and $2,859 per unit respectively, according to the average dealership statistics published by NADA Dealership Profiles. As daily reports of inventory shortages and challenges due to the microchip crisis continue, it will be interesting to see if/when these constraints catch up to the industry and halt the record profitability. Perhaps, we will begin to see some of these hiccups finally materialize in the financial performance either in the April or May figures when they are published.With rumors of tax rates rising, what impact could this have on Blue Sky multiples?KN: The Biden administration platform includes a material increase in capital gains taxes which directly impacts sellers of dealerships. As a result, some sellers who have been considering a sale are accelerating their plans and pursuing a sale in 2021 before a likely tax change in 2022. There are a number of attractive opportunities for buyers and dealers looking to expand so its expected values will remain robust. If/when tax rates rise, several situations might occur:Fewer sellers come to market, reducing dealership inventory and putting upward pressure on valuations.Less after tax proceeds to the seller pressures them to require higher valuations to sell their store.Higher taxes reduce consumer spending, lower sales, reduce dealer profits and bring valuations down. As a result, it’s difficult to predict the future but there’s no doubt higher taxes will have a ripple effect throughout the dealer buy/sell market. SW: My colleague David Harkins previously authored a post highlighting the proposed tax changes and their impact on valuation by comparing expected earnings under several tax bracket structures.Looking back, how did the Tax Cuts and Jobs Act (TCJA) affect multiples and values?KN: Lower taxes certainly provided a boost to consumers and helped ensure stability in vehicle sales in an environment where we were beginning to see declining sales. Corporate tax rate changes did little to help dealers as most are not C-corporations, and some dealers saw personal taxes go up due to the changes in deductibility of certain items. Overall, the rates kept the momentum rolling, nice profits for dealerships, and stable valuations for stores. Buyers were also able to forecast higher after-tax proceeds from their stores to justify paying more. We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. While the last year has been a turbulent one for the industry, auto dealers have been resilient in navigating the changing conditions. The first four to five months of 2021 have continued the momentum of the last half of 2020 in terms of dealership profitability and transaction volume. It will be interesting to see how long these trends will continue, or if auto dealers will experience any hiccups as market constraints threaten current profitability. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Q1 2021 Earnings Calls

Improved Profitability, Online Tools and Market Share, and High Valuations

The earnings calls in Q1 began with a focus on many of the same trends as prior quarters: increasing or record EPS despite inventory struggles as gross margin improvement drove operating leverage. The chip shortage has taken center stage, with cloudy expectations of when inventory levels might normalize. Contrast to factory shutdowns last year, dealers are faring much better as strong demand has improved vehicle pricing, benefiting both dealers and manufacturers. OEMs have tried to mitigate the impact of the chip shortage by removing certain features requiring chips, while others have prioritized more in-demand models to maximize profits.A couple of other trends require the proper framing of the subject to truly understand what’s happening. First, many execs talked about “pent-up demand” for parts and service work. If “pent-up demand” means parts and service revenue is expected to increase in the coming months, then that appears likely as vaccination rates increase and mandates are relaxed. However, on previous calls, many discussed the notion of consumers deferring maintenance on their vehicles since they could get by because they were driving less. Deferred maintenance has not been discussed as much, suggesting deferred maintenance activity has not meaningfully presented itself. In many instances such as the winter storms, execs noted that unit sales may have been delayed but service revenue losses would not be recovered.We also need to appropriately frame the degree to which online sales are truly “incremental,” or not cannibalizing traditional in-person sales. Execs highlighted online sales to customers who had not previously bought from them before as evidence that online tools were incremental. Given the long life cycle of vehicles, we are less convinced this necessarily says a consumer only purchased from their company because of the online feature. While Lithia noted nearly 98% of its online sales were to first time Lithia purchasers, we believe the 43% sold to customers outside of their retail market presence is a better representation of incremental sales, which is to say the company is improving its market share. While there were technical difficulties throughout the Sonic call reducing our ability to pull meaningful quotes, their investor deck similarly noted 30% of customers of its EchoPark segment (its stand-alone Pre-Owned operations) traveled more than 30 minutes to shop their inventory.On the other hand, Penske casts doubt on the notion that these sales were truly additional in the sense that consumers aren’t buying cars they didn’t otherwise need solely because the option to buy online now exists. While we tend to agree, it is meaningful if larger players are able to poach customers with the scale provided by their online platforms. Over the longer term, this could negatively impact unit volumes for smaller dealerships who choose to not take advantage of online options or are not able to meaningfully compete. Simply having a website may not be enough for the local Honda dealership to compete if comes up 5th on a Google search.The franchised auto dealer space is fragmented by nature. As such, the few publics are frequently asked about consolidation in the industry, as they have both the experience to operate at scale and a liquid market for their equity which allows acquired dealers to achieve liquidity without necessarily losing the upside of their dealership in a transaction (either receiving stock or investing cash from the deal into that stock). However, despite plenty of transactions in the industry, public auto dealers have not typically provided much financial information on their targets aside from revenues. In a recent investor deck, Lithia took things a step further, quantifying its intangible investment as a percentage of revenues as shown below: Many noted increasing valuations, and an analyst on the AutoNation call mentioned his M&A modeling at about 15% to 30% of sales. CFOs for multiple companies noted their focus on EBITDA multiples when doing deals, which are highlighted in theme #4. For perspective, the market ascribes about a 7.7x EV/EBITDA multiple for AutoNation with floor-plan interest treated as an operating expense as calculated below: Theme I: Microchip shortages have extended longer than initially anticipated, but strong demand, in part due to stimulus funds, has supported robust sales and gross profits. The industry’s limited chip supply has led to retail customer, particularly in hot selling models, getting vehicles first.“As it relates to the hot selling products as you point to, the OEMs are really great at this. And while the chip shortage is there, they've really been shifting their production to the faster selling vehicles. […] everyone is showing high margins. We didn't all of a sudden get that much better, it's simplistically supply and demand. There is that point where you're missing a lot of sales because you just don't have the inventory. […] the industry performs well and stability exist when there's probably a 60 to 70 days supply in the market. And right now with all the government spending that's going on and people coming out, the demand is going to be high right now, and the fear is the inventory won't be there to match the demand.” -David Hult, CEO, Asbury Automotive Group“As of the end of the quarter, we had a 41-day supply of new vehicle inventory, indicating we have well over a month's supply of vehicles on the ground and an adequate supply of in-transit that are replenishing our on-ground inventory every day. However, new vehicle margins may remain elevated in the near term due to continued microchip and other supply chain shortages, coupled with elevated consumer demand levels driven by additional stimulus funds. While select OEMs are experiencing reduced level of inventory, we currently have sufficient inventory to balance the current supply and demand trends expected over the coming months.” – Christopher Holzshu, President, and CEO, Lithia Motors“There is no question that there is more demand than supply, that is the headline. On the new vehicle side, there supply is tight, but shipments and production are disrupted with the chip crisis and will be for the rest of the year. But it's nothing like a year ago during the pandemic when we had the factory shutdowns. […] we've adjusted pricing to reflect that, and you've seen the improvement in our front-end gross. […] There is no reason to rush things out the door. You can’t easily replace it.” - Mike Jackson, Chairman & CEO, AutoNation“I've been amazed in the recent months, how we've continued to maintain pretty impressive sales levels with declining inventory levels. […] Also, the OEMs have adjusted. It seems that the only vehicles they're making are the ones that sell the fastest. So when they come off the truck, they go right to a retail customer. […] we're getting to the point where inventory is a problem, if not at this moment very soon. So ideal for us is about 45 days supply when we mix all of our different brands together. And as you saw, we ended the quarter at little over 30. And we're actually fine in the 30s. But we're a big truck market. When you get very far below 30 days of supply, you have trouble having many of the configurations that the truck customers want. And so that's where it starts to get a little challenging for some of our brands.” - Earl Hesterberg, President and CEO, Group 1 AutomotiveTheme 2: Service and parts continue to lag vehicle sales for many dealers, though those struggling for inventory are relying more on fixed ops. While a return to “normal” levels of miles driven should increase service demand, opinions among public dealers were mixed as to the degree there was pent-up demand from consumers deferring maintenance during the pandemic.“Obviously pent-up demand is a big driver. And we are starting to see that coming out of March where we actually started to finally see some real big volume increases year-over-year were great, but what we're really trying to do is figure out when will we start to get to a normalized recovery over what was really the 2019 kind of year, if we use that as a base case. And in the quarter, we saw ourselves about 5% up over that 2019 level. And prior to the pandemic last year, we were projecting a double-digit -- a low double-digit increase in our parts and service business. So we definitely see that trend continuing into April and we expect that to continue through the summer months as we kind of rally into customers coming -- normalizing their lives again and getting back on the road and driving their vehicles and then needing parts and service work.” – Christopher Holzshu, President, and CEO, Lithia Motors“We expect good things out of parts and service for the rest of the year. We see the traffic counts building. Our gross for RO is quite good as we've made some adjustments during the pandemic on that better inspections, better reporting, better selling skills with customers. And we we've added over 300 technicians back to our dealership base in the last 12 months. Very few hourly technicians, which tend to be less productive than flat rate technicians, and that helps us be more productive as a business. And we expect good things as miles driven continue to increase. And if vehicle supplies do become an issue, people will hold on to their cars and they will be in our shops more. […] The customer pay business is extremely strong […] but warranty we don’t control, and warranty has been a bit weak. […] it’s been collision and warranty, which had been soft over recent quarters.” - Earl Hesterberg, President and CEO, Group 1 Automotive“Well, there is no question that miles driven have come down […] in January, we were down 16% in parts and service revenue. Now, that’s really swung around. So, people are getting out. […] So, I think we’ve got to look sequentially how we’re going to look from March to April. This year will give us probably a better picture. But, I can say that there is definitely more momentum and more interest in the shop. […] So we still have some real opportunity there and just a matter of getting people out and that's strictly miles driven will drive that.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroup“March came back so strong, it was actually ahead of '19 pace numbers. And as we sit here in April, we're experiencing the same. So, the customers are back on the road, the service business is back. […] while we're feeling it on the variable side with some shortages with inventory, thankfully Parts and Service is picking up on that. […] We think there’s a lot of pent-up demand.” -David Hult, CEO, Asbury Automotive GroupTheme 3: While many dealers tout incremental sales on their online platforms, it’s important to understand which sales replace would-be in-person dealership transactions and which the company would not have been able to achieve, such as sales to customers where the dealer doesn’t have a physical dealership.“97.8% of our Driveway customers during our first quarter were incremental and had never done business with a Lithia dealership before. […] 43% of our [Driveway] sales are out of region and our average shipping distance is 732 miles […] so we're not really getting into that cannibalization of our existing pipeline.” -Bryan DeBoer, President and CEO, Lithia Motors“There is a lot of incremental [online] sales that we would not have received, and I made that comment, because looking at the information we weren't doing business with [those customers] before.” -David Hult, CEO, Asbury Automotive Group“I think that to a certain extent, it's substitutional where people have the opportunity to buy online, delivery at home, come to the dealership. […] we’re really not growing the business at this point incrementally. And I think that’s going to be the true test where we can tell the analysts in the market, we’ve actually grown our overall business by using the online tool.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroupTheme 4: While Lithia at least reports transactions in terms of price to revenue, multiple companies specified they think in terms of EBITDA multiples. While this might not be true for smaller acquirers, it may affirm the reasonableness of correctly applied EBITDA multiples from the publics.“[W]e generally think more about it as a multiple of EBITDA than revenue. And it's kind of in that high single-digit range, and returns are mid-teens.” - Joe Lower, CFO, AutoNation“[W]hen we evaluate an opportunity, we're looking at EBITDA multiples and then factoring in the synergies we think we can achieve, and then we look at the IRR relative to our cost of capital. And we need to see a margin there to deliver an accretive deal.” - PJ Guido, CFO, Asbury Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to 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.

April 2021 SAAR

SAAR has continued its impressive run in 2021, increasing for the second straight month to 18.5 million. This is a 3.1% increase from March 2021. As we have mentioned in our previous SAAR blog post, comparing spring 2021 SAAR to 2020 does not hold much merit, especially in April which experienced the weakest sales of the pandemic in 2020.For those of you who are curious however, April SAAR is up 112% from last year.Compared to April 2019, a better comparison in our view, April 2021 is up 12.1%. Because of strong demand, OEMs continue to rely less on incentive spending. According to JD Power, average incentive spending per unit in April is anticipated to be $3,191, a decline of $1,762 from April 2020 and $382 from April 2019. Still, average transaction prices are expected to reach another month high, rising 6.8% from last month to $37,572. This is the highest ever for the month of April and the second highest of all time behind December 2020. Incentive declines and price increases serve as a major win for dealerships this month.In regards the expected April statistics, Thomas King, president of the data and analytics division at JD Power notes:“While falling numbers of vehicles in inventory at retailers is the primary risk to sales results in the coming months, to date, low inventories have not had a material effect on aggregate sales results. Instead, they have enabled manufacturers and retailers to reduce discounts and consumers are demonstrating a willingness not only to buy vehicles closer to MSRP, but also to buy more expensive vehicles.”Inventory Scarcity Continuing to be in PlayThough pent-up demand and higher levels of disposable income continued to drive SAAR growth this month, a surprising factor we considered to be a headwind may have actually boosted sales for the month: the microchip shortage. As the shortage continues to drag on and has started affecting other industries and big names (such as Apple), the shortage has become a household topic and consumers are taking notice. Behind the increase in April SAAR may be consumers rushing to dealerships to snag a vehicle before they become more difficult to find in the coming months.Automakers, keen on not having to completely shut down productions, are trying to work around the chip shortage by removing features, which may be incentivizing consumers to pay up for them now.As Automotive News reports, Nissan is leaving navigation systems out of thousands of vehicles that typically would have them because of the shortages. Ram no longer offers its 1500 pickups with a standard "intelligent" rearview mirror that monitors for blind spots. Renault has stopped offering an oversized digital screen behind the steering wheel on its Arkana crossover. All of these feature cuts being for the same reason: to save on chips. This may become more prevalent going forward this year as the chip shortage is anticipated to continue.Despite automaker’s best efforts, inventory levels are suffering. While April inventory levels are not available yet, NADA forecasts that they likely will be at a decade-long low with no relief in sight. According to BEA, the inventory to sales ratio for March (the most recent data available) is at the lowest levels of the reported data going back to 1993, at 1.36 (though the chart below only shows data through 2015). According to Auto Forecast Solutions, the semiconductor microchip shortage has caused worldwide production to fall off to 2.29 million vehicles. Current forecasts put projected total vehicle production losses from the global chip shortage at 3.36 million units, with 1.11 million from North American production. With production flagging, dealers are having to draw down inventories to maintain and grow sales. However, April’s strong sales figure is unlikely to be sustainable as inventories cannot be drawn down forever, which explains why NADA forecasts 2021 SAAR of 16.3 million, or 11.9% below the April figure. Fleet Customers SufferingWhile the inventories of auto dealers are down, inventories for fleet customers are down even more, as OEMs continue to prioritize production for retail customers over fleet customers. Retail sales in April are estimated to be up 114% from April 2020 and up 23% from April 2019 according to Wards Intelligence. Meanwhile, fleet deliveries increased by 88% from April 2020, but fell by 42% from April 2019.This is especially poor timing for fleet customers as travel has begun picking up again and rental car companies and other fleet buyers are in need of inventory as many had to sell chunks of their fleets in order to preserve money during Covid-19, creating a situation that many are referring to as “car-rental apocalypse.” Due to the new car shortages, they are having to look elsewhere.As Yahoo News reports, Hertz is "supplementing its fleet by purchasing low-mileage, pre-owned vehicles from a variety of channels including auctions, online auctions, dealerships, and cars coming off lease programs," a Hertz spokesperson told Insider in an email statement.The result of all of this is that rental cars may cost consumers over $500 a day for an SUV, compared to prices of $50 a day 2 or 3 years ago. Until the chip shortage is back under control, travelers may be stuck having to pay sky high prices for rental vehicles on their next vacation.Looking ForwardThe best phrase we can think of to describe the auto industry going into May is “something’s got to give.” While demand for vehicles is still being fueled by pent up demand and traveling picking back up due to Americans getting vaccinated and a return to normalcy, the microchip shortage isn’t going away anytime soon.According to Mike Jackson, AutoNation’s CEO, that expiration date might even be 2022, as he notes “we performed despite the disruption from the shortages created by the chip disruption, which we expect to fully continue for the rest of this year."Stay turned for our blog next week when my colleague David Harkins breaks down the Q1 earnings calls and what the other leaders in the industry are noting about this year’s prospects.However, despite the lack of chips, if consumers are willing to make some sacrifices in terms of the number of features their vehicle has, SAAR may not see huge declines. If that is not something they are willing to do, the supply constraints may hinder SAAR’s recent run.

Year-End 2020 Auto Dealer Industry Newsletter Release

We are pleased to release our latest issue of Value Focus: Auto Dealer Industry Newsletter. The newsletter features a commentary on industry data from year-end 2020.Additionally, this issue includes two timely articles. The first article discusses the seven factors of a highly effective Buy-Sell Agreement for auto dealerships. When present, these factors can help reduce the risk of litigation upon a triggering event or business divorce.The second article discusses the computer chip shortage, including how computer chips are used in the automotive industry, how the chip shortage came to fruition, how it is currently affecting the industry, and what it all might mean for auto dealers going forward.Click the link below to download this latest issue.Value Focus: Auto Dealer IndustryDownload the Year-End 2020 Newsletter

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

We have previously written about six events that can trigger the need for a business valuation. In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation. The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer. For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets. Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations. These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below. A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital should not always be a rigid calculation. An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements. Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end. The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations. A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc. For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset. Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders. The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP. All have contributed to record performance for dealerships. The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements? Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven? The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation. For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages. According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24. Statistical data from 2014 through February 2021 can be seen below: So how should the working capital of an auto dealership be assessed? Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information. Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end. In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below. A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date. Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales. We can also look at the manufacturer’s requirement. This particular dealership had a net worth requirement and the more traditional working capital requirement. These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency. All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash. It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations. Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million. Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement. The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash. Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000. This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods. First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure. This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below: Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above. The final assessment of working capital focuses directly on the cash and equivalents. As discussed, management indicated that the Company had operational cash needs of $5 million. Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures. This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below: Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future. This example highlighted a dealership with excess working capital that was reflected in excess cash. Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations. As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership. However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations. For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation. ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership. The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value. Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales. None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation. Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes. Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation. For a valuation of your auto dealership, contact a professional at Mercer Capital today.

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Valuation Implications of a 28% Corporate Tax Rate on Blue Sky Multiples

Will Dealerships Become Less Valuable if Tax Rates Rise?

2017 Tax Cuts and Jobs ActTo get an idea of how Blue Sky multiples might change with an increase in the corporate tax rate, the simplest way may be to look at what happened the last time the rate changed. Fortunately for this analysis, we don’t have to go back too far. In December 2017, former President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. Shortly after his inauguration, President Trump indicated a goal of “15 to 20%” for the federal corporate tax rate, down from 35% at the time. Fast forward to September 2017, the Trump administration and congressional Republican leaders announced a tax framework that included a 20% federal corporate tax rate, which eventually settled at 21% when the bill was signed into law on December 22, 2017.On a statutory basis, a dealer structured as a traditional C corporation making $1 million in pre-tax earnings went from net income of $650,000 to $790,000, or an increase in value of 21.5% assuming no change in the P/E multiple. While this generally comports with the returns of the S&P 500 in 2017 (which increased 19.4%), this increase happened gradually over time. While there are many other contributing factors, it is evident in the chart below that the market likely priced in any favorable tax changes gradually throughout the year. Because the market generally trended upwards in 2017, it would be difficult to point to any one period of rapid increase related to optimism surrounding lower corporate taxes. However, because the market has historically trended upwards, it can be more difficult to attribute the rise to specific policies. While this paints with more broader strokes for the market, let’s consider Blue Sky multiples. Blue Sky Multiples Before and After TCJAWhile after-tax earnings likely rose for most dealers due to the tax law change, pre-tax profits by definition would not be impacted. Theoretically as noted above, a buyer should be willing to pay more for a higher return, so the value should increase if earnings go up. With the earnings stream utilized in Blue Sky multiples unchanged, an increase in value should be seen in higher multiples.From Q3 2017 - Q1 2018, there were no changes in the range of multiples for any brands despite the material decrease in corporate tax rates. This begs the question: Why not?If dealership values had increased by 21.5%, the average Blue Sky multiple would have increased from 4.85x in Q3 2017 to 5.89x in Q4 2017. This change also could have been more gradual throughout the year. However, multiples were largely unchanged.From Q1 2017 to Q1 2018, only five brands saw a change in their Blue Sky multiples. Subaru multiples improved by one full turn of pre-tax profits in Q2 2017 (from 4x-5x to 5x-6x), while Toyota, Honda, Chevrolet, and Buick-GMC saw more modest increases in Q3 2017. From then until Q1 2018, there were no changes in the range of multiples for any brands despite this material decrease in corporate tax rates. This begs the question: Why not? Well, there are numerous potential reasons.State of the IndustryIn the Q4 2017 Haig Report, private dealership values were judged to have fallen by an estimated 2.6% from the year-end 2016 due to increased expenses. Despite generally favorable macroeconomic conditions in the U.S., auto sales and gross profit per vehicle retailed were starting to trend down at the same time that dealership expenses are increasing, reducing profits. With years of annual volumes above 17 million, there were concerns about declines. While volumes in 2018 and 2019 were below the 2016 peak, they remained above 17 million. SAAR for 2015 through 2019 is shown in the below graph for perspective. As the pandemic reminded us all, volumes do not directly correlate with profits. In order to gain a broader perspective of the auto dealer market conditions, we’ve considered the stock price returns of the S&P 500, the Russell 2000, and the publicly traded franchised dealers in 2017. The S&P 500 paced the group with the aforementioned 19.4% return. Lithia was just behind at 17.3% as it continued to buy up dealerships which the market viewed favorably. The return on the Russell 2000 was 13.1%, well above all other auto dealer stock prices whose returns ranged from 5.5% (AutoNation) to negative 19.4% (Sonic). The trend was particularly bad through the end of August with all non-Lithia dealers down between 6.7% and 23.0%. SAAR followed this general trajectory and caught a nice bounce in September, which coupled with optimism over favorable tax treatment potentially aiding in the rebound. Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset gains, leading to minimal change in Blue Sky multiplesAfter the passage of the tax law and with some time to analyze any impacts, the Q1 2018 Haig Report noted positive and negative trends thusly:Positive Trends: “This remarkable era in auto retailing continues. We have enjoyed many years of low interest rates, cheap gas, and rising employment. Consumer confidence remains near its 17-year high and household wealth has never been greater. It’s true that dealership profits (and values) peaked a couple of years ago, but they remain close to record levels. The much-predicted downturn in sales has not yet happened. Congress even gave dealers a nice boost by lowering taxes and walking back pressure from the CFPB. Negative Trends: "While sales remain strong, there are some troubling vibrations coming from the disruptive influences of technology. Dealers continue to suffer from the degradation of gross profits due to the shift in pricing power from the retailer to the consumer thanks to various digital tools. And over the next five to ten years, electrification, ride sharing and autonomous vehicles loom as threats. Some well-respected industry leaders predict that the best days of auto retail are behind us, that profits will never return to current levels and that many dealerships will end up closing their doors.”Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset these gains, leading to minimal change in Blue Sky multiples. To take the analysis a step further, we consider the specific tax structures of privately held dealerships and transaction considerations, rather than comparing it solely to publicly traded companies which are required to be structured as C corporations.Tax Structure of Largest Auto GroupsBlue Sky multiples are calculated on adjusted pre-tax profits. This enables comparison between dealerships subject to different income tax rates. Differences in total corporate income taxes paid are usually due to two reasons: state/local tax rates and ownership structure (C corporation vs pass-through). First, let’s address state/local tax rates. Language in the Haig report from editions before and after the tax law change note, “dealerships in states with no income tax usually bring premiums to dealerships in high tax states.” This means that for a given range, say 5x-6x, dealerships subject to lower taxes are more likely to receive a pre-tax multiple on the upper end of the range. While not all dealerships necessarily fit into this range, one can infer that local tax rate differences may not ultimately impact the multiple by more than one turn of pre-tax earnings.Dealerships in states with no income tax usually bring premiums to dealerships in high tax statesMany dealers may also structure their companies to be taxed at individual rates (S corporation, LLC, etc.) instead of corporate rates (C corporation). The pass-through tax structure has been popular because it avoids “double taxation” when a dealer pays corporate income taxes on profits then taxes on distributions from net income to dealers after the payment of corporate taxes. For a pass-through dealer, their marginal tax rates only declined from 39.6% to 37.0%. While the initial tax framework proposed by Republicans included a maximum 25% rate on pass-throughs, the TCJA instead offered a 20% deduction for Qualified Business Income (“QBI”). For dealers in the top marginal income tax bracket, this could mean a pass-through rate as low as 29.6% (37% x [1-20%]). Implied increases in values are demonstrated below: As noted above, Blue Sky multiples derived from private dealership transactions are applied to pre-tax earnings, enabling comparisons regardless of elected corporate structure. This is intuitive because a buyer is unlikely to be concerned with the corporate structure of the seller. While corporate taxes declined, many dealerships are structured in this way. Therefore, a negotiation between a buyer and seller is likely to balance favorable income tax treatment against other factors on pre-tax income. As discussed above, industry conditions were relatively stable if not modestly declining. Anticipated Impact of Increasing Corporate Tax RatesUnder the Biden plan, a 28% corporate tax rate would decrease after-tax earnings for C corporations by 8.9% all else equal. However, as we saw after the TCJA, not all else is equal. The reverse may be occurring in 2021 with rising taxes being offset by more favorable industry conditions as many auto dealers finished 2020 with record profits despite a global pandemic.In 2021, rising taxes may be offset by more favorable industry conditionsHeading into 2021, looming threats associated with scale continue to exist, though this is not exclusive to smaller dealers. With online-only used retailers attracting plenty of equity capital from the public markets, larger players in the industry are feeling the pressure to grow themselves. This levels the playing field as buyers are equally incentivized to grow as sellers might be to capitalize on high exit multiples, forgoing the need to make significant technological investments.ConclusionSo, what does the TCJA tell us about the proposed increase in corporate tax rates under the Biden administration? The short answer is it depends. Buyers and sellers are likely more focused on determining the run-rate, or core earnings of dealerships after record profits in 2020 than what rate may or may not apply to them. Fear of rising taxes may motivate sellers to cash in, which would weigh on value if there’s excess supply of dealerships for buyers to choose from. In 2017, the opposite was likely true as bolt-on acquisitions became more costly as dealers were less motivated to cash out as more income fell to their bottom line. As we’ve demonstrated, an increasing federal corporate tax rate may impact some dealers, but for most that are structured as pass-through entities, changes in the top marginal tax bracket for individuals is more likely to impact dealer principals. And while the corporate income tax rate is important for the future earnings of a dealership, sellers are likely to be more concerned about the taxes they would need to pay after selling their business.Mercer Capital provides business valuation and financial advisory services that consider the potential valuation implications of changes in legislation and how this impacts auto dealerships and their principals. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

March 2021 SAAR

After a tumultuous February due to weather conditions, March SAAR has bounced back with a vengeance. March SAAR of 17.75 million units is the second-highest of all time for the month, just shy of March 2000. There are two main factors driving this increase. While the winter storms had a negative impact on February SAAR, it likely caused pent-up demand that helped drive sales in March. Beyond simple delays, flooding forced some to replace damaged vehicles. Secondly, the Biden administration passed a Covid-19 stimulus bill at the beginning of March, and $1,400 paychecks hit many Americans’ wallets. This influx of cash may have also spurred a massive increase in vehicle sales.Now more than 12 months into the Covid-19 pandemic, we don’t think that comparing March 2021 SAAR to March 2020 SAAR is prudent due to the change in the economic landscape (it’s a 56% increase for those of you who were curious). For the next couple of months, this year-over-year comparison will continue as spring 2020 SAAR values were horrendous as dealers scrambled to grapple with the challenging operating environment. We will instead try to show both a comparison to 2020 and 2019 levels. Even with this adjustment, March SAAR for 2021 was an increase of 44% compared to 2019.Driving March SAAR were sales of light trucks which accounted for 78.1% of all new vehicle sales in March 2021. This metric is a slight uptick from the 74% they accounted for in March 2020. Breakdown of SAAR by vehicle type as presented by NADA is below for March 2021:Inventory and Production ProblemsThe March record sales levels come at the same time as lean inventories and production problems plague the industry. Thomas King, president of data and analytics at J.D. Power, noted this:“At an aggregate industry level, Q1 inventories have been sufficient to meet consumer demand and delivered the opportunity for manufacturers and retailers to sell those vehicles with smaller discounts. Manufacturers who are experiencing supply chain challenges are prioritizing the production of their most profitable and desirable products, minimizing the net effect. There is no question that sales of specific models in specific geographies are being disrupted by low inventories, but consumers are nevertheless demonstrating their willingness to buy despite having fewer vehicles to choose from the in-retailer inventory.”It will be interesting to see how long inventory levels can meet demand, and if consumers will continue to be as flexible on car model choice. This factor likely hinges on the continuing chip shortage and how that impacts manufacturers during the rest of the year. We have discussed the chip shortage at length in a prior blog post, and it ultimately could pose a problem to the current growth trajectory.At the end of February, dealers had 2.7 million vehicles in stock or being shipped to stores, a 26% drop from the same month last year. The lack of availability has been more acute for crossovers and SUV models, including Jeep’s Wrangler and Chevrolet’s Tahoe, whose stock is running between 43-70% lower than last year. Pickup trucks are the most recent type to be impacted by the shortages, with dealers having about 414,000 trucks at the end of February, about half of what they had a year earlier. As a result, many consumers have had to order models from the factory or pick up vehicles in transit to dealerships.Long gone are the initial pandemic incentives to drive consumers to dealerships, and buyers are having a harder time finding bargains. According to JD Power, average incentive spending per unit is expected to total $3,527, a decrease of $888 and $262 relative to March 2020 and March 2019. High demand is driving record transaction prices, and reduced incentives are improving gross profit margins and overall profitability for dealers. JD Power notes that average transaction prices are expected to reach $37,286, just below the all-time record set in December 2020.Fleet SalesWhile new vehicle retail sales have been booming, fleet vehicle sales have not seen the same resurgence and remain depressed. According to NADA, manufacturers are prioritizing production of the most popular and profitable segments for retail customers. Fleet customers have had their orders pushed back or canceled for the 2021 model year in some cases. Fleet buyers typically get discounts for buying in bulk. Fleet sales have struggled mightily during the pandemic and have not seen the same type of rebound experienced by retail sales.JD Power notes that fleet sales are expected to total 180,200 units in March, down 33% from March 2020 and down 51% from March 2019 on a selling day adjusted basis. Fleet volume is expected to account for 12% of total light-vehicle sales, down from 26% a year ago. Fleet sales struggled inordinately compared to retail partially due to a decline in travel amid the pandemic. Although the introduction of a vaccine and more consumer confidence in travel should have been a bright spot for bringing back fleet sales, the reallocation of vehicles to retail due to the chip shortage is another blow to an already struggling segment of the industry. With supply low, OEMs are prioritizing buyers willing to pay top dollar, so fleet buyers are losing that allocation.ConclusionLooking toward the rest of the year, vehicle sales success is going to be contingent on being able to acquire inventory. Consumer demand is high, and if dealerships can navigate the chip shortage and lack of models, they may see more numbers like that posted in March. However, if the chip shortage worsens and dealerships are unable to acquire inventory, this may be a headwind.If you have any questions on SAAR and what it means in the broader context of a valuation of your dealership, please do not hesitate to reach out to any member of the Mercer Capital Auto Team.

Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions

The Opposite, Break-Even or Something In-Between?

My favorite TV show is Seinfeld. It's seemingly about nothing, but the situations and characters still resonate today.One of my favorite Seinfeld episodes is “The Opposite.” A brief (and incomplete) summary of the episode: George decides to turn his life around by doing the exact opposite of what he would usually do, and finally finds success, while Jerry keeps breaking even in life. Jerry marvels how things always just even out for him.What does this have to do with auto dealer valuations and the relationship of rent and real estate values in dealership acquisitions? In this post, we examine if the rent factor and value of the real estate all even out, just as Jerry Seinfeld’s character did in "The Opposite."The Impact of Rent and Real EstateOften dealership operations are organized in two entities: an entity holding the underlying real estate and an entity containing the dealership operations. We have chronicled the importance of normalization adjustments in the valuation process of the dealership operations including an assessment of rent. Since these entities are often owned by related parties, the level of rent should be examined.Dealers that own both the real estate entity and the dealership operations entity can control the amount of rent charged. Hypothetical buyers will assess the market rental rate and make adjustments to the valuation to keep this in line with the market.An ExampleWhy would dealers want to shift value and/or rental income to the real estate entity? Let’s examine this through an example highlighting increasing real estate values and one highlighting decreasing real estate values.Real estate is valued based upon a return of Net Operating Income. In our example, we assume a constant capitalization rate of 8% or a capitalization factor of 12.5x the rental income. In our example, this capitalization factor, or multiple, is higher for the real estate than the Blue Sky multiple of 6x, so the impact of the value of the real estate will have a greater impact on the overall acquisition value. Since Blue Sky multiples average around 6x, and range generally between 3-10x this will typically be the case. Fortunately or unfortunately, auto dealers cannot manipulate the underlying value of the real estate itself. Most, if not all auto dealership acquisitions will require a fair market value appraisal of the underlying real estate.Based on the assumptions above, the dealership operations would have a value of $3,000,000 (EBT of $500,000 times a Blue Sky multiple of 6x) and the real estate would have a value of $3,000,000 for a total acquisition value of $6,000,000 as seen below.Appreciating Real Estate ValuesIn times of appreciating real estate values, let’s assume the fair market value of the real estate increases by 15% to $3,450,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would increase to $276,000 and the resulting increase in rent would decrease normalized earnings to $464,000. While the real estate value climbs, the implied blue sky value for the dealership operations declines slightly since earnings are lower due to increased rent. However, the overall total acquisition value (operations + real estate) would increase by 4% ($6,234,000 vs. $6,000,000), despite the 7% decline in blue sky value as seen below.Depreciating Real Estate ValuesNow let’s examine the alternative where real estate values are declining. Let’s assume that the fair market value of the real estate declines by 15% to $2,550,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would decrease to $204,000 and the resulting decrease in rent would increase normalized earnings to $536,000. While the real estate value declines, the implied blue sky value for the dealership operations increases since earnings are higher due to decreased rent. However, the overall total acquisition (operations + real estate) would decrease by 4% ($5,766,000 vs. $6,000,000) despite the 7% increase in blue sky value seen below. For comparative purposes, we can also view this graphically: Seen differently, a 15% increase in FMV rent with no change in the cap rate of blue sky multiple shifts approximately 5% of the total value to the real estate. About the opposite is true for a 15% decline. ConclusionsThe relationship between rent and fair market value of the real estate has an impact on the components of an auto dealer acquisition. While the impacts may be opposite and felt on both sides of the two entities, the impact on the real estate can have a greater effect given lower capitalization rates and/or higher capitalization factors than most implied blue sky multiples.Back to the Seinfeld episode, does the rent factor and value of the real estate all even out? While a decrease in annual rent will materialize in a greater implied blue sky value all other things held constant, the total effect would not mitigate a corresponding decline in real estate values.While auto dealers that own both the dealership operations and the real estate can control the charged rental rates, they cannot influence the ultimate value of the real estate. Frequently, the rent paid by a dealership is either higher or lower than true market rent as dealers are more concerned with running the day-to-day operations of their business than trying to pinpoint rental cap rates. A proper valuation of the dealership operations will assess and adjust the charged rental rate to reflect the perceived fair market value of the real estate.To discuss the impact of the rental rate or for an assessment of the valuation of your dealership operations, contact a professional on Mercer Capital’s Auto Team.

Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions

The Opposite, Break-Even or Something In-Between?

What’s in a Multiple?

Blue Sky Multiples Improved in 2020 After a Rocky Start, and Buyers Weigh Multiple Years of Earnings

Multiples and Methodologies Moved Considerably Through 2020Prior to the tumultuous 2020, Blue Sky multiples for many brands could be relatively stable over numerous quarters. As seen in later charts, multiples don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM. However, the Covid-19 pandemic increased volatility in the economy to such a level that Blue Sky multiples reacted in a similar fashion regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the next year. Throughout most of 2020, Haig’s reported Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Now into 2021, Haig reports that buyers are using a three-year average of adjusted profits from 2018 through 2020 as the best prediction of future profits. This comports better with the approach taken by Mercer Capital. Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Dealers will likely need to ramp back up staffing levels and advertising to support sales, but strong demand relative to constrained supply has led to higher gross profits for dealers. While dealers are optimistic that the cost savings will be “sticky,” we note ten years of slow, consistent growth since the Great Recession led dealers to such an environment where there were excesses that could be cut out of the cost structure. We see earnings and sales levels normalizing which only bolsters the need to consider earnings in a multi-period context.Illustrative Example: LexusTo show the variance in Blue Sky values in 2020, we’re going to take pre-tax earnings for average luxury dealerships as reported by NADA and apply them to the appropriate multiple. Since Lexus was one of the largest movers and has the widest range, we’re cherry picking them as the best illustrative example.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 6.5x to 8.0x for Lexus dealerships. With 2019 pre-tax earnings of $2.2 million for the average luxury dealership, implied Blue Sky value for the average franchise would range between $14.5 million and $17.9 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $13.4 million to $16.7 million. By Q4 2020, multiples and earnings each increased significantly, and Lexus was up to a range of 8.0x to 10.0x as seen on the below graph. We note the range for Lexus dealerships has widened to two full turns of pre-tax earnings, or rather, two full years of profits. Applied to the three year average pre-tax earnings of the average luxury dealership, the difference in an 8x or 10x multiple represents a $5.3 million difference. High end multiple dealerships would have seen a value increase of $9.6 million ($16.7 million to $26.3 million) in that time, or 57.3%. While this appears high and all dealerships have their own unique characteristics, for context, the S&P 500 index was up 45.3% from March 31 to December 31. Without any context on the reported multiples (the red and green lines above), one might think that values were stagnant in Q4. However, the multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings. For the average luxury dealership, 2019 pre-tax earnings were $2.2 million, which were below 2018. Factoring in the higher earnings of $3.4 million in 2020, the 3-year average is $2.6 million. So, as seen on the graph, a dealership on the top end of the range saw their value increase by approximately $4 million as higher earnings are applied to multiples that held firm. Multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings.Deal Activity Can be Positively Correlated to MultiplesA multiple is a function of risk and growth, and certainly the outlook in March 2020 was higher risk than in in quarters prior to the pandemic. However, as seen below, very few transactions actually occurred during the initial economic decline as sellers were less interested in disposing of their most valuable asset at bargain prices. We note deal activity in 2020 was positively correlated with multiples, which makes intuitive sense and indicates a seller’s market in the back half of the year.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations partially recovered in Q2. With reduced uncertainty and higher profits, every brand except Volvo and VW received a higher blue sky multiple in Q3 2020 than Q4 2019 (pre-pandemic). In Q4 2020, the only multiple range that changed was that for Toyota which crept into the lead for mid-line imports.Luxury BrandsLuxury Blue Sky multiples followed the overall trend described above with drops in Q1, partial rebounds in Q2, then improved multiples in Q3, all relative to Q4 2019 multiples and earnings. Lexus saw the highest increase, from 6.0-7.5x in Q1 2020 to 8-10x in Q4. On the other end of the spectrum, Infiniti, Cadillac, and Lincoln continue to languish as brands without multiples, commanding a Blue Sky value range of up to $1.5 million. Each of these brands suffers from a myriad of issues, including costly facility upgrade requirements, which tend to weigh on Blue Sky values.Mid-Line Import BrandsMid-Line Imports multiples also followed the overall trend, as only VW’s Q4 wasn’t higher in 2020 than 2019 (each 3.0x – 4.0x). Nissan’s Blue Sky multiple in Q1 2020 declined to a paltry 1.5x on the low end, the lowest ever reported by Haig for any brand dating back to 2013. This was driven by troubles that began before the pandemic as corporate turmoil and an aging lineup weighed on dealer profits. At Q4 2020, this had rebounded to 3.0x – 4.0x, the highest for the brand since Q2 2018. Dealers that held on during the last few years have been rewarded. As noted previously, at the top end of mid-line imports, Toyota snuck its nose ahead of Honda, to pace the segment at 6.25x – 7.25x, on par with Jaguar/Land-Rover and Audi. Q2 and Q4 2020 were the only two quarters on record in which Toyota dealers have outpaced Honda, albeit only at a quarter turn multiple difference. Meanwhile, Subaru has caught up to Honda at 6.0x – 7.0x, a gap that has steadily narrowed since Subaru was closer to a 4.0x-5.0x multiple in 2016.Domestic BrandsDomestic franchises continue to move largely in lockstep with each other as Buick-GMC remains just below the others who command a 3.5x to 4.5x multiple. Domestics continue to outpace many of the mid-line imports, reminding everyone that vehicle pricing power is not the sole consideration in these multiples. Luxury vehicles frequently receive the highest multiples. However, three luxury brands continue to not even receive a multiple while Volvo and Acura are on par or below their domestic counterparts.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership and its corresponding franchise rights. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Six Events That Trigger the Need for a Valuation

Auto dealers, like most business owners, are focused on many aspects of their business: daily operations, strategic vision, competition, industry conditions, the state of the economy, etc. It is less common for auto dealers to be concerned if/when their business might need to be valued. Often, they are made aware of the need for these services by their trusted advisors including attorneys, financial planners, accountants, etc.What are common events that trigger the need for a valuation for an auto dealership?1. Estate Planning/Wealth TransferOver time, successful dealerships can accumulate tremendous value. Estate planning allows the first generation of a family to transfer wealth to the next generation through various mechanisms.Individuals and couples can take advantage of the lifetime exemption amounts by transferring value up to the current taxable exemption of $11.7 million for individuals or $23.4 million for couples over their lifetime.1 Gifting strategies can also utilize the annual exclusion amount of $15,000 per individual.Implementation of these strategies includes many different structures requiring the valuation of the auto dealership and the specific interest being transferred. A proper valuation assists in protecting the integrity of these transactions. Failure to support the concluded figures with a proper valuation can often lead to these transactions being challenged or audited, causing a later described litigation dispute.2. Death of a Dealer Principal/OwnerFor certain estates, an income tax return and Form-706 will have to be filed in a timely manner after the date of death. If the decedent is an owner of a business, or in this case an auto dealership, the value of the decedent’s interest will have to be valued. The valuation will need to be performed by a qualified business appraiser that can support the value of the dealership and specific ownership interest through accepted methodologies.3. Buy-Sell AgreementIn a prior blog post, we discussed the seven elements of a highly effective buy-sell agreement. This document, along with other corporate governance documents, describes the process and criteria for a business valuation and often requires an initial valuation to set the stock price for triggering events that will be governed by the document. Further, some buy-sell agreements require updated valuations at regular intervals or upon the occurrence of future triggering events. Following the provisions in these documents and maintaining regular valuations can aid in limiting or avoiding litigation disputes.4. Strategic PlanningBusiness valuations can also assist auto dealers with strategic planning. Not only can a valuation provide an indication of value at a specified point in time, but successive or regular valuations can track value over time. These valuations could be helpful for auto dealers contemplating incentive programs to reward ownership to key management. Auto dealers can also discover the value drivers of the current appraisal and set goals to enhance value through the improvement of those value drivers over time.5. Potential Sale of DealershipAt some point, successful dealers may reach the point where they contemplate a possible exit event. If there isn’t a viable second generation to continue the operations, a sale of the dealership may be the next best option.The auto dealer industry proved to be resilient and adaptable posting strong profitability for 2020 and continuing into 2021. Industry transaction activity also appears high for both public and private acquirors. Most auto dealers that have owned a dealership for a period of time have likely been contacted at one point or another with some interest either by phone or through the mail.If you have not had a recent business valuation, how can you evaluate any offers or know what your dealership is worth? A business valuation can inform you as to the value of the dealership and manage expectations to assess potential offers.6. Litigation DisputeThe next three events that we will describe all fall under the umbrella of litigation, but each is a unique event.Shareholder DisputesShareholder disputes can come in many forms: breach of contract, wrongful termination, damages, etc. In any of these scenarios, the value of the entire dealership and a specific ownership interest will be contested. A valuation and possibly testimony can assist the attorneys and/or triers of fact determine the outcome of the case. Certain components of an auto dealership’s value, such as Blue Sky Value, can also be critical to the case. Taxation DisputeIf a proper valuation was not utilized in an estate planning transfer or if the valuation is being challenged by the IRS, another form of litigation involving a taxation dispute could arise. These disputes require similar elements as in a shareholder dispute – valuation of the dealership, value of specific ownership interest, and possibly testimony. A unique element of taxation disputes is that generally an expert’s valuation report also serves as their direct testimony should the matter end up in trial. The valuation report must communicate the expert’s methodology and support for their conclusions for the value of the dealership and any applicable discounts such as lack of marketability, lack of voting rights, etc. Family Law DisputeWhile not a popular topic, dealers or their spouses in the midst of divorce would also be in need of a business valuation and potential expert witness services. In a divorce, all of the couple’s assets and liabilities need to be compiled and valued to assist the attorneys and trier of fact in the division of assets and other matters.Some assets, such as bank accounts and real estate, are easier to value. Other assets, such as business assets can be more difficult to value. In the auto dealer universe, these business assets can consist of more than one entity. Many dealerships are organized where the dealership operations and franchise agreements are contained in one entity, while the underlying real estate may be owned by a separate asset holding entity.In this example, both entities would need to be valued and the methodologies to value each are different. Some auto dealers may also own additional entities such as separate repair and body shops or re-insurance companies that also might require a business valuation.ConclusionBusiness valuations are triggered by numerous events. By knowing the events that dictate the need for a valuation, auto dealers can be more educated in the use of these services. As we have previously written, the auto dealer industry is unique to valuation in the methodologies employed, the terminology communicated, and the financial information utilized. When a valuation need arises, auto dealers are best served by someone who is both a valuation expert or an industry expert.Contact a professional at Mercer Capital to assist with you a business valuation or consultation of your auto dealership and related businesses for any of these events or others.1 The lifetime exemption amounts, estate income tax rates, and corporate income tax rates could all be subject to change with the new administration in the White House and change of control in the Legislative Branch. These changes could have a dramatic impact on business valuations and the need for related services.

February 2021 SAAR

Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January

As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was. Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices. As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid. Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!

February 2021 SAAR

Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January

Q4 2020 Earnings Calls

Sales Return Quicker than SG&A Expenses, But Inventories Continue to Lag Amid Chip Shortages

Fourth quarter earnings calls started similarly to the previous quarter, with significant increases in earnings per share as lower volumes were supported by higher margins and SG&A expense reductions related to personnel and ad spend continue to benefit dealers. Executives generally believe a portion, though not all, of this expense savings will be sustainable. Productivity has increased as employment levels have remained low despite improving activity.Long-term, however, low headcount and insufficient ad spend maybe a drag on incremental sales.February 2021 SAAR was already anticipated to be down from February 2020. February 2020 was the last month prior to the pandemic, did not have supply constraints related to chip shortages, and had a leap day fall on a Saturday.To compound problems, winter storms in certain areas of the country kept more people at home than mask mandates have in recent months. Most earnings calls occurred before the storms or there was little mention of them. AutoNation referenced January volumes in line with projections, affirming their forecast of approximately 16 million for 2021, though there was no discussion of the impact of the winter weather. Sonic indicated the storms closed some stores in their Texas, Birmingham, and Nashville markets, though they anticipate a quick rebound. Total volumes were down 12.6% in February 2021, but declines were closer to 5% after adjusting for selling days. However, we expect to see significant year-over-year improvements as we reach the one-year milestone of the pandemic.The proliferation of SPACs in 2020 and continuing into 2021 has been an interesting byproduct of the pandemic. While this has typically been for more speculative operations including EV startups, an article from Automotive News indicates some franchised dealers are mulling the possibility of accessing public capital markets through a SPAC. LMP Automotive, an ecommerce and facilities-based auto retailer already traded on the NASDAQ, closed on its first wave of auto dealerships on Friday, bringing the publicly traded group to seven. With these acquisitions, LMP will be considered in future earnings calls blogs.On the other hand, the number of public players could well decrease in 2021 as Lithia indicated consolidation amongst the public players may be the best way to ward off competition from used-only players like Carvana. Franchise agreements have long been seen as a hurdle for such significant consolidation, which was downplayed by Lithia. This prompted the question on future calls, and while many anticipate continued consolidation within the industry, Group 1 expressed doubts OEMs would approve such a deal, and AutoNation flat out rejected the notion as they are already the largest public auto dealer.Theme 1: Microchip shortages represent the latest hiccup in dealers’ quest to restore inventory levelsWe sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupWe're quite inventory constrained right now. As you know and we expect the new car inventory situation to continue to be constrained for probably the first half of the year. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveNew vehicle inventory levels remain constrained and we expect demand to exceed supply for an extended period. Given these dynamics, we remain focused on optimizing our business in the current operating environment. We expect industry sales to approach 16 million in 2021 with strong retail sales growth compared to last year. We have seen a solid growth in ‘21, with January trends in line with our annual forecast. - Mike Jackson, Chairman & CEO, AutoNationTheme 2: SG&A to gross profit anticipated to be structurally lower going forward after efficiencies gained during the pandemicSo we have to be below 70% [SG&A as a % of gross profit]. I think to be competitive. I think the world's moved on. So, yes so certainly we would expect to be significantly below a 70% level. As we've mentioned previously, although we do not expect this level to be sustainable, we do expect there to be significant improvement going forward versus pre-COVID levels. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveDuring 2020, we took targeted measures to improve operating efficiencies and manage expense throughout our entire organization, fundamentally improving our cost structure. As a result, we achieved all-time record adjusted SG&A expenses as a percentage of gross profit of 68.1% for the fourth quarter of 2020, down 560 basis points from 73.7% in the fourth quarter of 2019. Full year 2020 adjusted SG&A expenses as a percentage of gross profit were 72.9%, 400 basis points better than 2019. For 2021, we expect to continue to see a benefit of our permanent SG&A reductions. - Jeff Dyke, President, Sonic AutomotiveSG&A expense as a percentage of gross profit declined 940 basis points to 69.7% and declined 800 basis points on an adjusted basis to 71.1%. Our success in this area can be attributed to a reduction in T&E, advertising, vehicle maintenance, administrative, personnel and other fixed costs. We estimate that approximately 125 million to 150 million in SG&A costs have been eliminated across our various businesses. - Roger Penske, Chairman & CEO, Penske Automotive GroupWe also remain very active in managing expenses and we achieved SG&A as a percentage of gross profit of 61.4%. Our focus on gross profit and expense management once again produced a great quarter. […] We also changed our production per employee when the downturn hit, and we stayed disciplined with that. […] I think we'll certainly be in a much better position from an SG&A standpoint than we were pre-COVID. But where exactly […] I think there's too many variables to call that right now. “We sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupTheme 3: Lithia suggests public consolidation may be beneficial for entrenched franchised players seeking to ward off competition from rapidly growing used competitors. While other players doubt the likelihood of OEM support, industry-wide consolidation is anticipated to continueWe do believe that the best way to combat the entire industry is that the public should roll up, okay? And whether or not that can or can happen, we will tell you this, it's not restricted from framework agreements. We believe that we have strong relationships, and our national limitations in those 3 or 4 manufacturers that do have a ceiling established doesn't preclude us from buying any of the other public or joining forces. I do also like the fact that many of them appear to be replicating some of the strategies that we've been focused on over the last 3 years. And we're pleased to see that because I believe that the new car retailers, if we can cut off the stream of used vehicles to the used car new entrants in the space, and all they can really get is auction cars or late-model cars, the margins that we can make in the over 3- year-old cars are massive that the new car dealers could have a stronghold on the space for decades to come, even if electrification changes thing or connectivity or all the other things that are in all – in the back of all of our minds over the coming quarters, years and decades. - Bryan DeBoer, President, and CEO, Lithia MotorsI think there is a natural consolidation that needs to occur among the U.S. auto retail networks. There are simply too many dealers in many of the brands, not all of them, many of the brands to operate in efficient privately owned distribution network. […] And it's becoming more and more a big player game just because of capital investment and amortizing technology costs and the cost of developing people and things like that. So, I think that trend accelerates and that is the reason that there will be a lot of acquisition opportunities as they have been in the past few years […] And I think that will benefit the remaining larger retail groups. And I think it will benefit the OEMs. And so I think there, we're going to continue to move to an era of bigger partners for the OEMs. And - so I think that is very much a catalyst for these M&A opportunities. Now, the advantages of scale you know it would seem that we're not nearly as big as many other groups, yet we've been able to create a cost structure that's just about as competitive as any. So there is a diminishing point of return on scale, I think but there is a benefit to diversity of markets and brands that we can continue to benefit from. And there is potentially a widening of the gap between the ability to operate efficiently - for a smaller operator compared to a bigger operator. - Earl Hesterberg, President and CEO, Group 1 AutomotiveWhat I have experienced is that when you become as large as we are and you make an acquisition, takes a brand Z and you already own 25 brand Z stores and you want to buy number 26 and number 27, and the negotiation with the manufacturer, they will ask, okay, we will improve number 26 and number 27, but let me tell you what you have to do from store one through 25in order to get approval for the next increment. And if you really add that demand on to what you are acquiring, it really changes the return on investment and so the higher you climb the mountain the more difficult it becomes to keep climbing. […] So, the whole issue of consolidation whether two smaller public traded companies could come together, I can’t say, because I don’t have one of the smaller ones. But I can tell you as far as us acquiring one. I don’t see that’s just going to happen, because you immediately run into a problem of too much density in a given market that you are going to have to divest a significant part of what you just thought, at least that would be for us. So, overlap and too much density in the given market is a real genuine issue for us and so we will not be acquiring any other publicly traded company. I don’t see it pay off to the finish line. - Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to 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.

January 2021 SAAR

SAAR Hit Highest Levels Since the Pandemic Began, but Several Factors Could Hinder February’s Growth Prospects

January 2021 SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) increased to 16.6 million from 16.2 million in December. Though this is a decline of 1.4% from the same period last year, this is the highest that SAAR has been since the pandemic began. Light truck sales were behind this growth, as they captured 77.8% of all new vehicles sold in the past month. Below is a full breakdown of vehicles sold by type for the month. [caption id="attachment_36204" align="alignnone" width="940"]Source: NADA[/caption] The year began with some inventory constraints (down 20% from January 2020), and as such, manufacturers have not had to spend as much on incentives such as those that were offered at the beginning of the pandemic. According to JD Power, the average incentive from manufacturers on new vehicles is on pace to be $3,639 per vehicle, a decrease of $510 from a year ago. Furthermore, lean inventories mean that cars are spending less time on the lots.The average number of days a new vehicle sits on a dealer's lot before being sold is expected to fall to 51 days, down from 70 days from last year. Average transaction prices, according to JD Power, are expected to be up 8.4% compared with January 2020.Thomas King, president of the data and analytics division at JD Power noted this about January SAAR: “January continues the strong performance observed in Q4 of 2020 and points to a positive outlook for the balance of 2021. The growth in retail sales is encouraging, especially as it is being achieved with higher transaction prices and lower incentive levels. While retail demand remains strong, non-retail sales are still recovering, which is hampering total vehicle sales and SAAR.”As King noted, fleet sales are continuing to struggle as widespread travel is still down due to the COVID-19 pandemic. According to Ward Intelligence, retail sales are estimated to have increased by 7% from January 2020, as fleet sales dropped by 24%. Retail sales have been up year over year in four of the last five months, while fleet sales have declined for 13 straight months. For SAAR to fully recover, it might depend on a reverse in these declines. With vaccines being distributed, consumers may have renewed sense of confidence in their travels and could bring back demand.With February’s SAAR release coming in the next few days, there are already some insightful forecasts available for where the numbers will fall. Cox Automotive is anticipating February's sales pace to reach nearly 16.3 million, down from January’s 16.6 million pace. Despite this projected decline, the circumstances in February could have made things much worse. The two most significant events being the chip shortage and the winter storms through Texas and the South.Global Chip Shortage Continues As recently mentioned on this blog, the chip shortage is a pervasive issue for auto dealers going forward. According to LMC Automotive, the global chip shortage is expected to reduce North American production by some 230,000 units in the first quarter. For perspective, multiplying this by 4 for a simple annualization would reduce 2021 volumes by nearly 1 million. Consulting firm AlixPartners expects the shortage will cut $60.6 billion in revenue from the global automotive industry. Different manufacturers are anticipating different levels of impact (see table below). This is an unfortunate situation, as many dealerships were counting on inventory recovery in 2021 to help boost sales, and the full extent of the situation is still unknown. As we’ll note in next week’s post, public auto dealer execs continue to kick the inventory stabilization expectations can down the road now to mid-2021. With the February SAAR release on the horizon, those numbers may shed more light on this ongoing situation. Storms Ahead for February SAAR (Literally)The event that might have the most immediate impact on February SAAR is the winter storm that went through Texas and the South between February 13–17. I’m based in Mercer Capital’s Dallas office and during that time we had no choice but to work remotely (the pandemic has given us lots of practice with remote working). Some of my coworkers were without power and water for days, sending videos of water pipes bursting in apartment buildings around them. Luckily, I only lost water for one day and my biggest tribulation of the week was forgetting to buy groceries before the storm and as a result, walking 2 miles to an open taco store and buying 15 to last me for a few days. Many were not so lucky, and we hope that everyone is recovering and getting back to normal from that time period.As a result of the storm, the concerns of most people across the state were around making sure they had food, water, and energy, and probably not trying to get out and buy a new car. This week of “shut down” may have an impact on overall February SAAR. However, as Texas and the rest of the south continues to thaw, the industry is anticipated to recover, though, in some areas, infrastructure damage and continuing water scarcity could depress some Texas markets for days to come.However, there may be a silver lining for Ford dealerships. Ford confirmed that it had seen an 18% spike in online searches for the F-150 during the power and water crisis in Texas. What could be driving these searches? News broke that Texas truck owners were using the generators on F-150s to heat homes. As one 2021 F-150 hybrid owner stated, “You’re living your life normally, and all of a sudden, you’re thrust into the dark… I think it got around 9 degrees. It’s been in mid-20s and low 30s. You don’t expect that in south Texas. You don’t expect to lose power when we have nuclear, natural gas, wind, and solar power. The truck gave us light at night, TV access to catch the news and weather. It helped give us a little bit of heat and a good pot of coffee.”Furthermore, Ford sent letters to its Texas dealers encouraging them to use the hybrid trucks as needed. "Due to the urgent and unprecedented weather situation in Texas, a number of our local dealers are using all-new Ford 150s equipped with Pro Power Onboard to help in their communities. Approximately 415 trucks fall within this effort. We're proud to pitch in to help Texas in this time of need." Mike Levine, Ford North American product communications manager said.We hope that this post finds everyone affected by the winter storms safe and with power and water, and that March has better weather in store. If you have any questions about SAAR and what it might mean for your dealership, feel free to contact any of the professionals on the auto dealer team at Mercer Capital.

Seven Factors of a Highly Effective Buy-Sell Agreement for Auto Dealerships

A Roadmap to the Valuation Process

A few of our recent auto dealership valuation engagements have involved disagreements among family members and the next generation or what might otherwise be termed a business divorce. Inevitably, one of the first questions I always ask "Is there a buy-sell agreement or governance document that will provide a roadmap into the valuation of the business and the respective subject interests?" Often the answer is "I’m not sure, I don’t know, or maybe but we haven’t reviewed it in some time."We’ve also encountered plenty of examples where these documents exist, but they are either poorly written, do not contain the necessary information, or have not been contemplated in many years since the drafting of the document. In Stephen Covey’s popular management book, he discussed the seven habits of highly effective people. In this post, we cover seven factors of a highly effective buy-sell agreement for auto dealerships and also touch on several other considerations.1) Standard of ValueThe standard of value establishes the parameters for how the auto dealership will be valued. It should be clearly defined and give clear indications for how the participants in a hypothetical transaction should be viewed: buyer, seller, motivations, knowledge of facts, etc. The most common standard of value is fair market value and is generally defined as a hypothetical buyer and a hypothetical seller both having reasonable knowledge of the business and all relevant factors and neither being under any compulsion to buy or sell.The other most common standard of value in buy-sell agreements is fair value. Simply put, fair value is fair market value without consideration of any applicable discounts for lack of control and lack of marketability for the subject interest. Fair value is often used in legal proceedings. The difference between these two standards of value and the lack of clarity in defining which standard is governed by a company’s buy-sell agreement is often the impetus to litigation.2) Level of Value Level of value is a valuation concept describing the differences between various “levels” of a company’s value. Levels of value can include financial control, strategic control, marketable minority interest, and non-marketable minority interest. Each level has a distinct difference in the amount of control one can exhibit over the operations of a business and/or their ability to sell an interest in that business. For the layperson, the levels of value ultimately dictate whether premiums or discounts would be applied to the subject interest being valued.3) Define Triggering Events If the goal of a buy-sell agreement or governance document is to provide a roadmap for the valuation, then it’s important for these documents to define the events that will be governed under their parameters. These events are often referred to as triggering events and can include the death of an owner, termination of an owner, divorce, change of control, etc. By defining the triggering events, it will be clear when the document will be enacted and enforced and when it will not apply. For example, selling or gifting a minority interest in the business to future generations is not likely to be a triggering event in this context and almost certainly would not be valued at anything besides the nonmarketable minority level of value.These events can also have unique ramifications on auto dealerships. For example, each franchised dealer has a dealer principal that has to be approved by the manufacturer. The death or divorce of a dealer principal can also pose challenges as the transferability of that interest and title of dealer principal is not guaranteed and cannot occur without approval from the manufacturer.4) Avoid Formula Pricing Often these documents contain a formula or a methodology to value the business. The formula might consist of the applicable financial information to consider and the multiple to apply to those metrics to determine the value. At the time of the drafting of the buy-sell, these formulas might establish the shareholder's perceived value of the business. If considerable time has passed between the drafting of the document and the triggering event, these formulas and concluded values could be stale and outdated. As we’ve previously discussed in this space, the auto dealership industry is unique from a valuation perspective. Traditional formulas such as EBITDA multiples often utilized in other industries are not as informative in this industry. The drafting attorney may not be as familiar with the nuances of auto dealership valuation. Even if an industry-appropriate metric, such as a Blue Sky multiple or formula is used, it is likely be dated in a short period of time. National auto brokers (Haig Partners and Kerrigan Advisors) publish and update these Blue Sky multiples by manufacturer quarterly. As we’ve seen during the COVID-19 pandemic, operational conditions and perceived franchise values can change both quarterly and over a longer time horizon. Additionally, dealerships could evolve over time and acquire or divest of different franchises that could drastically change their operations and perceived value.Finally, what adjustments are to be considered? Even if a buy-sell agreement has language providing for a multiple to be updated with the current market environment, significant one-time or non-recurring income or expense items can inflate or depress value.5) Specify Valuation DateThe buy-sell agreement should explicitly define the date to be used for the valuation. Typically, the date of valuation would be at or near the triggering event depending on its proximity to the timing and availability of current and reliable financial information. A proper valuation should consider what is reasonably known or knowable as of the date of valuation. Any ambiguity in defining the valuation date or the financial information to be used could have a significant impact on value. Since franchised auto dealers must submit monthly financial statements to the manufacturer, an appropriate valuation date might be set to be the month-end prior to the triggering event.6) Defining Appraiser Requirements Who should perform the valuation? Often buy-sell agreements will utilize language such as a “qualified appraiser” and may even include certain valuation credentials such as an Accredited Senior Appraiser (ASA), someone who is Accredited in Business Valuation (ABV), or a Certified Valuation Analyst (CVA) from national valuation accrediting organizations. Since the auto dealership industry is so unique, these credentials may not be enough. Should your buy-sell agreement also require that the appraiser have specific industry experience? Finally, independence is key. We recommend selecting a third-party valuation firm with experience in valuing auto dealerships so that the appraiser will be qualified and unbiased.7) Make It a Living Document How often does a company have a buy-sell agreement or governance document drafted only to be placed in an electronic file, a desk drawer, or a file cabinet and never reviewed or contemplated again? The value of an effective buy-sell agreement is to provide a roadmap for how to value the dealership at a triggering event. If the document was never used since drafting, can it be reliable?Effective buy-sell agreements are not only drafted, but they are utilized. Some require ongoing valuations at annual anniversaries or other timeframes to provide the owners with a value indication that could be used for strategic planning or contemplation of an upcoming triggering event.If the document didn’t clearly contain the items in this post and was never used since drafting, it could create confusion leading to litigation or the buy-sell agreement could be ignored in an eventual litigation. Frequent use or at least consideration of the terms considered in the document are likely to be much more relevant in a litigation context.Conclusion and ConsiderationsAn effective buy-sell agreement can provide a roadmap to defining the valuation process through many challenging events during the lifetime of an auto dealership. As we’ve discussed, the document should contain and clearly define these seven elements, among others, to accomplish that goal.Other considerations to contemplate are the premise of value, funding mechanisms for repurchase, and managing expectations. The premise of value will establish whether to determine the value of the dealership if it continues as a going-concern business as opposed to liquidation. Funding mechanisms and repurchase requirements can also dictate the mechanical treatment of certain assumptions in the valuation such as the impact of recognizing life insurance proceeds at the death of an owner to establishing a market for the subject interest that could possibly impact the applicable discount for lack of marketability.Does your auto dealership have a buy-sell agreement or governance document? When was it drafted? Who drafted it? Does it contain and discuss these seven key items? If it contains formula pricing, would buyers and sellers find the methodology employed reasonable today? These are all items that need to be considered.To discuss the impact of your buy-sell agreement, assist you and your attorney in drafting an effective buy-sell agreement, or determine the valuation of your auto dealership at a triggering event, contact a professional at Mercer Capital today.

Public Auto Dealer Profiles: Lithia Motors

From 1996 to 2002, six new vehicle retailers became publicly traded companies. While these companies have expanded their footprint, there have not been any more publicly traded new vehicle retailers since. Online used vehicle retailers have recently IPO’d and EV startups have used SPACs to come to market during the pandemic, but these are not comparable to privately held franchised dealerships that can sell new vehicles.This is the first in a series of profiles of these six public new vehicle dealerships. The goal of these profiles is to provide a reference point for private dealers.Dealers may benefit in benchmarking to public players, particularly those that are significantly larger with numerous rooftops. Smaller or single point franchises will find better peers in the average information reported by NADA in their dealership financial profiles. Public auto dealers also provide insight as to how the market prices their earnings.We’re starting with Lithia Motors (LAD) because of their targeted annual acquisitions of $3-5 billion in revenue, which will require plenty of deals with private dealerships, representing a potential exit strategy. Lithia has also already reported their 2020 earnings, so the early bird gets the worm.Lithia Motors Locations and BrandsBased in Medford, Oregon, Lithia has over 200 locations throughout the U.S. largely focused on the West Coast, Texas, and the Northeast. Management indicated 100% of consumers in the U.S. were within a 400-mile radius of the company’s fulfillment network, with this density shrinking to 100 miles in the northwest and 200 miles in the Southwest, South Central, and Northeast. According to the Automotive News Top 150, Lithia sold the third most new retail units in 2019 at just over 180 thousand, trailing only AutoNation and Penske Automotive Group. Lithia added seven dealerships in 2019, making it the most acquisitive dealership in the country that year, a trend they carried into 2020 and is anticipated to go forward. As seen in the table below, nearly 45% of Lithia’s revenues in the last quarter came from Toyota, Honda, and Chrysler. While just under 30% of the company’s revenue came from luxury vehicles (8% BMW/Mini), luxury volumes made up only about 22% of unit sales. Lithia is relatively balanced, seemingly agnostic to brand and segment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. With numerous acquisitions and industry-wide improving gross margins in 2020, Lithia’s revenue and gross profit have grown at an annualized rate of 9.2% and 13.7% in the past three years. Lithia’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume-based incentive fees, operating income can be negative for dealers before accounting for these profits. For Lithia, other income (excluding interest expense) amounts to only 7.4% of pre-tax profits due in part to differences in reporting.Implied Blue Sky MultipleIn this blog, we’ve discussed how Blue Sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied Blue Sky multiple investors place on Lithia Motors. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Lithia’s Blue Sky value per share is approximately $228. With pre-tax earnings per share of approximately $26.8, Lithia’s implied Blue Sky multiple is 8.53x. Luxury franchises trade for multiples in this ballpark, but luxury makes up only approximately 30% of Lithia’s sales. For comparison, domestic brands make up a similar percentage for Lithia with multiples closer to 4x. Still, the scale of Lithia’s operations and significant growth profile lend it to higher multiples, and there would certainly be intangible assets other than franchise values. Primary Pitch to Investors: Growth and “Driveway”Seeking to meet the market’s insatiable demand for growth, Lithia unveiled its five year growth plan halfway through 2020. The company is targeting annualized revenue growth of 31% for the next five years with a goal of $50 billion in revenue (from $13 billion in 2020). Lithia describes itself as the largest participant in a fragmented $2 trillion revenue industry, combining both the traditional new franchise retailers and the used-only auto retailers.Lithia has emphasized and invested in its omnichannel efforts called “Driveway.” This is an eCommerce solution the company compares to Carvana and Carmax. Lithia notes a higher gross margin than Carvana, and the company’s long-term strategic advantage lies in the combination of an eCommerce option for consumers supported by a larger network of traditional retail locations, which increases options for online shoppers in adjacent markets. Lithia sources 60% of its inventory from trade-ins, giving it robust offerings in the online used vehicle space.In 2018, Lithia also invested $54 million in a partnership with Shift Technologies, which competes with Driveway, Carvana, Carmax, and Vroom. According to the most recently available filing, Lithia owns 13.8 million shares of Shift, which went public via SPAC in October, worth approximately $140 million based on last close.The company’s recent investor presentation showed the company added $3.5 billion in annualized steady-state revenue, though it does not specify the impact of the pandemic on this estimate. Lithia’s acquisitions also required an intangible investment of 25% of annualized revenues indicating the company may have paid greater Blue Sky values in 2020 as Haig Partners and Kerrigan Advisors each indicated market multiples increased in 2020 despite declining revenues.Seeking to acquire strong brands and grow profits, Lithia highlights five keys when acquiring dealerships:New Vehicle Market Share: Lithia looks to improve dealerships that are underachieving the OEM’s market share performance goals. They target improvement from 75% of the OEM target to 125%.Used Vehicle Units: The company seeks to triple the number of used vehicles sold per store per month.F&I Profit: By focusing on cross-selling F&I, Lithia seeks to improve GPUs from $700 to over $1,450.Service & Parts: Similar to improving market share targets, the company seeks to improve CSI scores. In addition to improving relations with customers, this focus positively influences relationships with manufacturers.SG&A Reduction: Lithia seeks to use its scale to reduce SG&A expense to below 65% from approximately 90% for its targets pre-acquisition. In summation, Lithia aims to improve pre-tax margins of its targets from under 1% of revenues to above 3%. To quote the CEO, Bryan DeBoer, on the recent earnings call, “Lithia’s model has always been to buy value-based investments that underperform.” Targeting dealerships with thin profit margins also allows Lithia to grow revenues and increase its distribution network while potentially reducing the amount of Blue Sky paid. However, as noted in the Haig report, lower margin dealerships can often attain higher Blue Sky multiples, resulting in favorable returns for sellers as well.ConclusionLithia’s aggressive growth strategy may pay off if they don’t overspend on dealerships over the next five years. Depending on which markets they target, they’ll also need to be strategic to avoid cannibalizing their current sales as they expand. Investors may well reward them if they hit their growth targets, but private dealerships also stand to benefit from an aggressive buyer in the market. This will be particularly true if Lithia falls behind its growth targets, as private dealers looking to exit may be able to extract more blue sky value out of the deal. Dealers in markets competing with Lithia may also see a shift in their pricing strategy, as the company touts 43% of its transactions with customers as “negotiation free,” potentially implying more competitive (read: lower) prices.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance and strategic investment initiatives of the public new vehicle retailers gives us insight into the market that may exist for a private dealership. 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.

The Chip Shortage Is Making It Feel Like 2020 All Over Again

Last year, many of our blog posts touched on the subject of inventory shortages due to plant closures from the pandemic. However, after stay-at-home orders were relaxed and plants got up and running again, there were high hopes among the major public dealers that inventory levels would return to pre-COVID levels in 2021 and dealerships could meet consumer pent up demand. However, manufacturers are facing a new obstacle on the production line that is a threat to reaching these inventory goals. All over the world, automakers (and other industries) are grappling with a shortage of computer chips.In this blog post, we discuss the necessity of chips in the auto making process, how the chip shortage came to fruition, how it is affecting the industry, and what all this might mean for auto dealers going forward.Small But MightyWhen considering all of the different digital products that you might use on a day to day basis, there is likely one specific thing that they all have in common: computer chips. While cars might not be the first thing to pop in your head when you’re thinking about digital technologies, they also rely on them for many different functions.A mainstream car has more than 100 microprocessors.As OEMs continue to innovate and more features become standard, consumers have benefitted from an enhanced experience while vehicle prices have increased. These advances have also increased the reliance on semiconductors, which have become a crucial part of the supply chain. Car companies can use them to power the modern-day technology in their vehicles, such as the engine, Bluetooth capabilities, seat systems, collision and blind-spot detection, transmissions, Wi-Fi, and video displays.As Kristin Dziczek, a senior industry analyst with the Center for Automotive Research (CAR) notes, “Today’s automobiles use a huge number of computer chips, chips in the engine, chips in the seat, chips in everything, but they’re in tight supply right now.” A mainstream car has more than 100 microprocessors.How It StartedLike many other production struggles that have occurred in the past year, the COVID-19 pandemic is at the root of the shortage of chips. With the new normal of being indoors, demand for electronics increased substantially, boosting demand for microchips. Xbox and Playstation also released their latest consoles in mid-November. The last consoles brought to market by these companies was in 2013, so the timing of this launch exacerbated these issues.While demand for electronics was increasing at the beginning of the pandemic, demand for cars had waned, and thus, automakers like General Motors, Toyota, and Subaru, were forced to close factories at the onset of the pandemic. In accordance, this caused overly conservative demand estimates to be made. However, once the plants reopened, demand was much higher than anticipated, and the chips necessary to fulfill the demand just were not there.Chipmakers tend to favor consumer electronics because their orders are larger than those of automakers. The annual smartphone market is more than a billion devices compared with fewer than 100 million cars. Automaking is also a lower-margin business, leaving manufacturers unwilling to bid up chip prices to avoid risking profitability. Automakers in China were the first to feel the impacts of the shortage, primarily due to it being the world’s biggest auto market recovering from the pandemic, but now the shortage has spread to auto manufacturers across the globe.Current ImpactsMajor auto manufacturers are already starting to react to the chip shortage. Ford is the latest, cutting production of its top money maker, the F-150 pickup truck, due to the chip shortages. The impact could be significant, as the Ford CFO John Lawler notes, “Right now, estimates from [chip] suppliers could suggest losing 10% to 20% of our planned first-quarter production.” This could mean a loss of profit of $1 to $2.5 billion in 2021. Ford is proactively trying to mitigate risk in other parts of their vehicles subject to supply chain disruption, and has hinted that they might be investing in battery production to avoid a similar issue on that front.With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021.Ford is not alone in production cuts though, as it joins General Motors, Nissan, Volkswagen, Toyota, Mazda, and Subaru in cutting output due to the semiconductor shortage. With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021, as reported by consulting firm Alix Partners as Bloomberg reported.As of right now, there is no clear answer for when the chip shortage will be alleviated. Macquarie Capital expects auto production to be affected until mid-2021, as chipmakers up their production, while data firm HIS Markit said the shortage could last until the third quarter this year. As the shortage has worsened in the past week, 15 senators have asked President Joe Biden to secure the funding necessary to implement clauses related to chips in the National Defense Authorization Act, in the hopes it could spur production in the U.S.Potential Impacts for Auto DealersOverall dealership supply is most likely going to be impacted by the chip shortage, and for shoppers who have the money to buy new cars and are expecting deals, they may be disappointed by the selection available. This is a major blow to auto dealers, especially after the public companies on their last earnings call were anticipating inventories to stabilize in 2021. Stay tuned for our upcoming earnings call blog post to hear what public dealers prospects on the matter.All else equal, shortages could squeeze profits for OEMs if they are all vying for the same limited amount of chips. These costs would likely trickle down to dealers who would attempt to pass them on to consumers. However, it is a bit too early to say for certain what the overall impact will be on dealership profitability. A lot of it may depend on how significant the disruption ends up being and how long until things normalize once again.Regardless, it is not the optimistic news that many were hoping to kick off 2021 and signals continuing struggles as the industry tries to shake off the effects of this pandemic. Though the current circumstances are uncertain, the COVID-19 vaccine offers some hope that things will begin to stabilize soon. The current microchip shortage may not be ideal in the current circumstances for inventory levels and dealership profitability, but the impacts will not last forever.If you are interested in learning more about how this may impact the value of your dealership, feel free to reach out to any of us on the auto dealer team. We hope everyone is continuing to stay healthy during this time!

Changing Advertising Trends for Sunday's Big Game

How the Auto Industry Is Spending Advertising Dollars

So it’s the week of the big game. What are you most looking forward to? The game? The food – appetizers and snacks? The halftime show? Or maybe the commercials? Inevitably, all of us probably have this same list of things in some particular order. The festivities will probably look entirely different this year with smaller gatherings and pandemic protocols affecting travel and public viewing at restaurants and sports bars. But what will this year's commercial line up look like?The big game has historically been a showcase for national companies and advertisers to try and leave a lasting impression on a mass audience. Each of us probably has a running short list of the most iconic and memorable ads from prior games: the Budweiser frogs, Wendy’s “where’s the beef?” or Coca-Cola and mean Joe Green tossing his jersey to the childhood fan. But, these advertisements aren’t for the faint of heart – they are very costly. 2021 is no different with Viacom/CBS having an asking price of about $5.5 million for each 30-second spot. The price tag serves as a barrier to entry for all but larger national brands or those few each year trying to splash onto the scene.The auto industry, specifically the OEMs, are no strangers to advertising during this annual football holiday. Looking back over the last five years, an average of seven auto manufacturers have participated with a high of nine advertisers during the February 2016 game and a low of five at the February 2019 game. The chart below displays the number of advertisements in each of the past five games, plus this year’s game. What’s different in this year’s game? Well for starters, the pandemic has adversely affected television ratings and the public’s consumption of sporting events. The Fox Network, which broadcast last year’s game, had sold out its commercial inventory by Thanksgiving of the prior year. This year’s broadcast partner, CBS/Viacom, only recently sold out its commercial inventory in the past week. Traditional national brands and advertising participants (such as Coca-Cola, Anheuser-Busch/Budweiser, PepsiCo, and Avocados From Mexico) are sitting out this year from running in-game advertisements. How will the auto industry participate? As of this week, only three automotive companies/brands are scheduled to run in-game advertisements which would mark the lowest number of participants in the last five years. In addition to the lower number of auto spots, the messaging choice is also a reflection of trends in the auto industry over the past year: electric vehicles and online/remote retail sales. There are three companies participating in this year’s game. General Motors – advertisement focusing on their ultium battery technology for use in electric vehicles.Cadillac – advertisement focusing on their lyriq electric crossover vehicle.Vroom – advertisement parodying the pains of the dealership buying experience to highlight their safely delivered, contact-free online buying experience. Will this year serve to be an aberration or is it a reflection of advertising changes impacting the auto industry and auto dealerships?Auto Dealership Advertising Trends and SpendingAs we have previously discussed, three expense categories that declined in 2020 that helped auto dealerships maintain profitability despite declining retail sales were advertising, personnel, and inventory costs. Let’s examine some of the trends within advertising spending.The auto industry has historically placed heavy reliance on television and print advertising. According to Zenith Media, television is the second largest advertising channel for auto advertisers and as a whole, auto advertisers spend nearly 32% of their advertising budgets on television, whereas the average brands only spend 27% of their advertising budgets on television advertising.How are auto dealerships and auto advertisers adapting? First, consider several statistics revealed by LocaliQ in their Automotive Social Media Marketing strategy article.72% of Americans use at least one form of social media.78% of all car buyers consider social media in choosing their next vehicle.47% of car buyers spend time on Facebook Marketplace according to their study. Over the past year, the pandemic forced many auto dealerships to shift to offering more online and remote retail services. While overall advertising spending was expected to decline in 2020, the automotive industry had already been spending more advertising dollars on digital media. The chart below shows the total automotive industry’s digital spending in the U.S. for 2017 through 2019, along with anticipated figures for 2020 and predicted figures for 2021. While advertising spending had been increasing in digital channels prior to 2020 and is predicted to return to prior levels in 2021, the digital component to the overall advertising budget still remains a small percentage. In another view of digital spending, Zenith Media found that auto brands lagged behind average brands in this category also, with only 42% of budgets for the auto brands dedicated to digital channels in 2019 as compared to 49% by average brands. Where are individual auto dealerships spending more advertising dollars in 2020? One channel highlighted by the studies discussed previously is Facebook. Facebook and Google are the two premier places companies across a variety of industries advertise and according to a study by Dealers United, the average dealership spent nearly $2,300/month in June 2020 as compared to only $1,600/month at the start of the year. These numbers were only expected to maintain those levels or climb higher as the year came to a close. Digital media advertising allows auto dealerships to optimize the way car users search and shop using mobile devices. These outlets offer the dealership better tools to track their customers, interact with them, and offer a means of customer feedback and improved customer service. The costs for some digital channels can be a fraction of the cost of traditional television and print advertising. Combine lower costs and more targeted advertising, and online strategies seem like a no brainer. Maybe this plays a role in the decline in advertisements at this year’s Big Game. While the three commercials this year also highlight trends we’ve seen this year with EVs and online sales, there’s another trend among the advertisers. Digital ads may be more targeted and have higher conversion rates/ROI, but there is no substitute for national TV advertising for events like the Big Game if you want to get a big message out to as many people as possible. We see this in politics, which really heats up around election day. Vroom, GM, and Cadillac are all looking to make big statements. For the traditional brands, GM and Cadillac want to be known as going in on EVs. They aren’t going to be gas-guzzling forever, and they don’t want consumers to view them as the old guard that can’t adapt to new technology. GM recently announced its intention to be fully electric by 2035; advertising an EV during the game is just another way of amplifying this message. Vroom is also trying to get their name out there. While their IPO may have generated some buzz last year, it seems like just about every IPO this year saw huge gains, so the typical branding advantage of such a jump was probably more muted. Consumers are more likely to have heard of Carvana, as it has a few more years on Vroom, and its car "vending machines" are well known by now. For a company like Vroom to compete, they have to spend considerable advertising dollars on getting their name out there and drive traffic to their site. So far, Carvana seems to be winning this battle, so an ad during this year's game just might help Vroom catch up. ConclusionThe auto industry and particularly the manufacturers will always maintain some level of national television advertising. Over the last several years and specifically the last year, auto dealerships have shown the ability to adapt their operations including how and where they choose to spend their advertising dollars.As you watch the big game this weekend, pay attention not only to the memorable commercials but which brands are advertising this year and which brands are not. Also, look at their messaging. If you’re an operator of an automobile dealership, how are you choosing to spend your advertising dollars and how has that changed in the last year? What is your message?To discuss how these trends are affecting your dealership and their impact on the value of your dealership, contact a professional at Mercer Capital today.

Headwinds and Tailwinds for Auto Dealers

Your Flight Itinerary for 2021

If you’ve ever been on a flight, you know that the pilot and plane itself can only do so much in determining how quickly you get to your destination. A key factor is which way the wind is blowing. If the pilot announces that there are headwinds, you can expect your flight time to be on the longer side. The opposite is true with tailwinds, and you can expect to arrive at your destination more quickly under these circumstances.Similarly for auto dealers, sometimes it doesn’t matter what the dealership’s management is like or how good the dealership itself is, as certain headwinds and tailwinds can make it harder or easier to achieve its goals. Below, we have considered some headwinds and tailwinds heading into 2021.Headwinds for Auto DealersRegulations in the Industry As we mentioned in the blog post which looked into how each presidential candidate’s policies would impact the auto industry, the end of the Trump administration most likely points to an end in regulatory rollbacks in the industry.In 2012, the Environmental Protection Agency and the National Highway Traffic Safety Administration issued regulations that would increase average fleet-wide fuel economy standards to 54.5 miles per gallon by 2025. Though President Trump had pushed back on the regulations, the Biden administration has indicated that they are in favor of these regulations and fuel economy and emission standards set by the Obama administration. Although the administration change could prove beneficial to EV manufacturers, especially in terms of Biden’s plan for providing further government assistance for these companies, an increase in regulations could make cars more expensive, which are already historically expensive.Though higher prices due to inventory shortages during the pandemic have helped margins for dealers, further increases in vehicle prices could dissuade consumers from purchasing vehicles. Dealers will have to hope they are able to continue to pass such costs along to consumers, which may prove more difficult with the proliferation of internet shopping, which brings us to our next headwind for traditional franchised dealers.Consumer Confidence IndexWhen consumers are more confident, they are more willing to make large purchases (i.e. vehicles). This makes it an important indicator for determining headwinds and tailwinds for auto dealers. Unfortunately, between the COVID-19 pandemic, unemployment rate jumps, and uncertainties regarding the election, there was a decline in the Consumer Sentiment Index, as seen in the graph below. As the pandemic rages on and unemployment rates remain high, it’s tough to tell when consumer confidence will return to pre-COVID levels. However, the Biden administration’s plan for a $1.9 trillion stimulus bill could have a positive impact if it is passed. Internet-Based SalesInternet-based sales for vehicles have had their moment in 2020 with the COVID-19 pandemic. Most notably in this industry was the Vroom IPO, whose success has shown investors are confident that internet-based sales for vehicles will be a larger part of the industry going forward. However, internet-based sales strategies can increase revenue at the detriment of margins as increased price transparency further decreases gross margins, posing a potential headwind for the industry going forward. Vroom and others have been able to undercut prices with significant inflows of capital. However, Vroom’s stock price is down a bit over 40% from August highs. If investors sour on the viability of the online used car sellers, this headwind could turn into a tailwind for traditional franchised dealers.Tailwinds for Auto DealersAverage Age of Vehicle FleetA study from IHS Markit found that the average age of vehicles on the road rose to 11.9 years this year, one month older than in 2019. This increase can be partially attributed to declines in new vehicle purchases as a result of the pandemic. Furthermore, vehicles, in general, are lasting longer and increases in prices have dissuaded some consumers from purchasing new vehicles.While new vehicles made up 6.1% of vehicles on the road last year, IHS Markit predicts the final data for 2020 will be closer to 5%. This increase in the overall vehicle age represents pent-up demand for new vehicles. To the extent the pandemic has persuaded would-be buyers on the margin to forego purchases, increasing vehicle age portends greater demand for parts and service operations, which is a positive tailwind for the industry.InventoryAs we mentioned in our New Year’s Resolutions blog post, inventory is the name of the game in 2021 as production has ramped back up, and many of the public dealerships anticipate their inventory levels to fully recover. Because of the inventory shortages caused by manufacturing shutdowns in 2020, many shoppers who were looking for specific models, especially trucks, might not have been able to find what they were looking for. With inventory recovery on the horizon, many dealerships are hopeful this will no longer be a problem. The stabilization of inventory levels presents arguably one of the largest tailwinds for the industry going into 2021. However, it is important to note that a computer chip shortage that has been garnering attention at the beginning of this year poses a threat to this inventory resurgence.Interest Rates With interest rates near zero and the Federal Reserve chairman Jerome Powell indicating that will continue for the near future, auto dealers stand to gain. Lower interest rates make cars and trucks more affordable for consumers financing these large purchases. If interest rates stay low as they are expected to, most consumers will be able to finance vehicles at affordable rates. This should help to offset our headwind above with rising prices.Public Transportation SentimentWhile the COVID-19 pandemic has been devastating for public transportation, auto dealers may be able to gain a new customer base or expand their current one as a result. With Americans relying further on personal vehicles to avoid being in public areas, cars have become more important than ever to many Americans trying to limit exposure as much as possible. Furthermore, with more companies bringing their employees back into the office, this could have a positive impact on car sales as well.The graphs below show both public transit unlinked trips and vehicle miles traveled. While vehicle miles traveled has almost recovered from pre-pandemic levels and are down only 9% in October 2020 compared to October 2019, public transit ridership has fared much worse, down 62% in the same time period. This decline in consumer sentiment for public transit presents a positive tailwind for the industry.ConclusionWe hope that this post is helpful; however, as 2020 made painfully clear, these are only predictions based on current trends. It’s impossible to know exactly what lies ahead. For now, we can all just hope that the ride won’t be as bumpy as 2020 was.If you’re interested in how these trends may affect your dealership or would like to discuss a valuation issue in confidence, feel free to reach out to Mercer Capital's Auto Dealer team.

Should You Diversify Your Family Business?

The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures

December 2020 SAAR

2021 Predictions for Auto Dealers

Coming into 2020, vehicle volumes in the U.S. were anticipated to dip below 17 million light vehicles sold. The industry had eclipsed this mark in each year since 2014, though 2019 cut it close. Like most industries, automotive retail got off to a strong start in 2020. While SAAR was just below the 17.0 million mark at 16.9 in January and 16.8 million in February, the boost of a leap year falling on a Saturday had total volumes at just shy of 2.5 million, up 4.5% from 2019. While dealers were hopeful volumes would remain high, we all know what happened next in March and April, which put to rest any notion of 17 million vehicles sold. In the U.S., 14.46 million units were sold in 2020 representing a 14.7% decline and the lowest total since 2012. Normalizing only March and April to their 2019 levels, volumes in 2020 would have been 15.7 million, showing nearly half the 2020 decline occurred in just those two months.The decline can also be attributed to a significant reduction in fleet sales as the COVID-19 pandemic’s impact on travel caused several major rental car companies to cancel orders. In December 2020, monthly retail sales appear to have actually improved 0.5% from 2019, compared to a 33% decline in fleet volumes. Viewed another way, fleet sales represented only about 14.3% of total volumes in 2020, compared to a 19.6% share in 2019. We touched on the impact of retail vs total SAAR last month.The pandemic had a material impact on the sales process in March/April and the sales mix from fleet to retail, predictions from before the pandemic about sales volumes weren’t that far off the mark once stay at home orders were relaxed and dealers figured out how to navigate the new protocols. By September, SAAR had returned above 16 million. However, no month in 2020 reached seasonally adjusted volumes of 17 million, a mark reached seven times in 2019 and every month but two in 2018. So, while nobody could have predicted the depths of the pandemic, we see that the initial expectation of a lower run rate may have been correct.Eisenhower once said, “Plans are worthless, but planning is indispensable.” According to Scott Galloway, Professor at NYU Stern School of Business, “the same is true for predictions – they matter for the strategy and data behind them. Predictions are useless, but scenario planning is invaluable.” I find this quote to be even more telling as it appeared in a piece about predictions for 2020, which just about everyone missed.Heading into 2021, we’re going to make some predictions. While they may or may not prove true in 2021, we believe this exercise is beneficial for auto dealers who should be looking forward to what the year might bring and prepare themselves should these trends materialize. While nobody could have predicted their need for Clorox and face masks, the pivot to digital offerings and more targeted advertising was already in motion prior to the pandemic. Intentional planning can help prepare for what lies ahead, whether or not things actually unfold as you project. It’s the preparation itself that’s meaningful.Inventory Constraints Lessen and Fixed Operations ReturnsThis prediction is based on the trends seen at the end of 2020 continuing through 2021. As vaccine distribution ramps up, auto manufacturing should continue as well. The speed of each of these will likely be a significant factor in total volumes in 2021. Fixed operations, particularly collision, were diminished in 2020 with fewer road miles driven. Due to inventory constraints and potential affordability concerns, among other reasons, consumers shifted towards used vehicles. We anticipate normalizing inventories and an improving economy should both tilt the mix back towards more new vehicles. However, the recent increase in used vehicle sales should increase the average age of vehicles on the road, which tends to spur more business for dealers’ service and parts departments. Since this is the highest margin business for auto dealers, we see tailwinds in terms of total profitability. While higher volumes can bring in more bonus money to dealers on the backend, at the end of the day, profitability is what drives value for auto dealers.Crossovers Remain Popular as Low Gas Prices and High EV Battery Costs Don’t Make the Trade-Off Worth It to the Bulk of Consumers, Yet.Pickup trucks accounted for 19.7% of market share, higher than all cars combined (small, midsized, and large) excluding luxury. Combined with crossovers (43.3%), SUVs (8.7%), and vans (4.7%), light trucks accounted for 76.4% of all sales, up from 72.1% in 2019 and 69.2% in 2018. Larger vehicles have become increasingly popular with consumers, and low gas prices and improved MPGs reduce the costs of the trade-up in size. Even inventory shortages and reduced incentives haven’t deterred demand in this segment. Incentives in December 2020 were down 12.7% from 2019, which along with the continued shift to higher priced vehicles, pushed average transaction prices to all-time highs of just over $38 thousand per vehicle.Nearly 96% of vehicles sold in 2020 were gas or diesel-powered, with EVs making up only 1.4% of the market. While there has been significant investment in this space, and an incoming Democratic administration portends a shift towards sustainable fuels, we do not anticipate this to materially accelerate in 2021. Instead, most of the EV progress anticipated in 2021 is more likely to be along the lines of infrastructure investment, legislative assistance, and vehicle improvements. While many manufacturers such as Volvo have made claims their cars will be all-electric by 2030, we see that progress being back-ended. While Elon Musk claimed EV battery costs could be cut in half, but this will still be years from now. Ultimately, until the sticker price can meaningfully compete, EV’s won’t reach the majority of consumers.SAAR of 16 Million (Above NADA’s Forecasted Figure of 15.5 Million)NADA is forecasting a SAAR of 15.5 million in 2021, making our prediction slightly on the bullish side. While the industry appears set for a second straight year below 17 million, improved margins could leave dealers with higher gross profits, which would be a welcomed trade in the industry. According to NADA, headwinds for the vehicle market in 2021 include continued increases in COVID-19 cases, which could lead to production disruptions along the vehicle supply chain. They further noted a global shortage of semiconductor microchips used in many facets of auto production and tight inventory on dealer lots, particularly for pickup trucks. Alternatively, tailwinds for 2021 include a potential economic boom in the second half of the year once a coronavirus vaccination is widely available, and Americans return to work from WFH. Auto retailers also stand to benefit if consumers continue to prefer personal vehicle ownership over rideshare services and public transportation. Finally, low interest rates keep cars affordable, and the Fed has indicated it intends to continue to be accommodative, which should support vehicle demand.Conclusion As auto dealers know, SAAR is a decent gauge on the industry, but it tells us very little on its own. While we believe it’s important to track, we recognize the inherent limitations of just volumes. In the proper context of incentive spending, profitability, and other key metrics, SAAR can be helpful. While dealers can see how their volumes compare to wider industry trends, dealers need to focus on the underlying trends within their local markets to contextualize performance to make sure they are staying ahead of the curve.For an in-depth analysis of how your dealership fits in the auto dealer marketplace, contact a member of Mercer Capital’s Auto Dealer team today.

Valuation Considerations for Auto Dealership Entities with Multiple Franchises

The valuation of an auto dealership can be a challenging and complicated process. The structure of most auto dealerships consists of an entity holding the actual dealership operations and a separate entity owning the real estate and building. Often the latter is a related party entity that charges the dealership rent for use of the land and building. Occasionally, the real estate and the dealership operations are contained in the same entity.We are all used to the local dealership in our town: Bill Jones Honda, Steve Smith Chevrolet. But what about the larger auto groups that have multiple franchises organized in the same entity? How are they valued and what special valuation considerations apply to them?Financial ReportingFranchised auto dealerships submit dealer financial statements to the manufacturer on a monthly basis. These dealer financials contain valuable information about the various departments, including profitability by department, overall number of new and used vehicle sold, individual models sold, etc. How does that differ for entities that contain multiple franchises under one structure? In our experience, those dealerships submit a combined dealer financial statement to each manufacturer. For example, if an entity owned a Chevrolet and a Honda franchise, they would submit an identical dealer financial statement displaying the combined operations to Chevrolet and to Honda. This can make it difficult to assess the individual financial performance of each franchise.Most dealership financial packages will contain various support schedules that can provide additional insight. There should be a breakdown of new vehicle sales and gross profits by manufacturer provided or the auto dealer would maintain that data.With this information, a valuation analyst can determine the contribution of each franchise to the combined operations by percentage of revenues, gross profit, or new or total units sold. Generally, these combined statements do not allocate the selling, general and administrative expenses by franchise, so individual franchise income statements are typically not available. We will later discuss how to incorporate this information into the valuation of an entity with multiple franchises.Profitability and BenchmarkingEstablishing the ongoing earnings of a dealership is critical to its determination of value under both the income approach and the market or Blue Sky approach. If individual profitability of each franchise isn’t discernable in a combined entity, how do you evaluate the profitability of the dealership?We have previously discussed in this space the use of industry benchmarking tools to assess a dealership’s profitability. One such tool is NADA's Dealership Financial Profiles. These benchmark studies are released monthly and are categorized by the type of dealership including Overall Average, Domestic, Import, Luxury, and Mass Market. An analyst can use these tools to determine a blended overall industry profitability figure for the dealership based on the composition of each franchise to total operations and the specific category of dealership that each franchise represents.The table below lists the average pre-tax income margins for the dealership categories for 2018 and 2019: For example, let’s say you had a fictitious combined entity with a Chevrolet and a Honda franchise and that each comprised 50% of the total combined operations of the entity. As a guide, you could compile a blended profitability measure of 2.80% for 2019 to account for the domestic franchise (3.10% x 50%) and the import franchise (2.50% x 50%). These comparisons to industry profitability margins are not rigid but do provide a framework to assess the subject dealership's performance against its peers. Since Chevrolet and Honda also would both fall under the “Average” category, one might be tempted to simply pull the average figure. However, as we see in our example, this may lead to a lower benchmark than is ultimately appropriate. Franchise and Blue Sky Values Multi-franchised entities can also pose a challenge since each franchise has inherent value and all franchise values are not created equally. The perceived franchise value is often reflected in a multiple of pre-tax income referred to as Blue Sky Value. Leading national firms that specialize in auto dealer transactions, such as Haig Partners and Kerrigan Advisors, publish their observed Blue Sky multiples by franchise each quarter.Examples of Haig’s published Blue Sky multiples for the second and third quarters of 2020 based upon dealership category appears in the table below: Using our previous example of a combined fictitious entity with a Chevrolet and Honda franchise, it’s clear from these Blue Sky multiples that it would be inappropriate to value the entire entity just based on Honda’s perceived value (6.00-7.00X) or Chevrolet’s perceived value (3.50-4.50x) alone. One technique that can be utilized is to establish a blended Blue Sky multiple for the two franchises based on the composition of each to the total combined operations. As we discussed earlier, this can be estimated based upon revenue or units sold composition of the two franchises in the subject dealership. Based on a 50/50 composition of each of these two, it would be reasonable to estimate a blended Blue Sky multiple of 4.75X on the low end and 5.75X on the high end using Haig’s Q3 2020 multiples. (Note: The valuation requires more in-depth analysis than just a high-low average.) A blended Blue Sky multiple would incorporate the inherent difference in values of the two franchises so as to not undervalue or overvalue the combined subject dealership in our example if either an exclusive Chevrolet or Honda multiple were considered. After a direct valuation of the entity is performed, the corresponding Blue Sky value could be measured against this blended multiple. For example, if the conclusion of value for this example implied a 9x Blue Sky, this exercise would illustrate that the valuation conclusion or some of the underlying assumptions were flawed. Recent Acquisitions and DivestituresMost valuations of auto dealerships require the analysis of prior years’ performance and results. The golden period for valuation analysts seems to be reviewing five full historical years. In our projects involving entities owning multiple franchises, we often see activity within those franchises owned in those prior five years. It can be valuable to ask if there have been any acquisitions or divestitures of franchises during that historical period of reviewed financials. First, the analyst wants to establish that the comparison of historical years to one another are apples to apples. If an entity had sold off or discontinued a franchise, the earnings related to that particular entity should not be considered in any current value of the subject dealership. In the case of a divested franchise, the impact of those sales and earnings should be removed from prior year results as much as possible. This won’t always be possible for the same reason we can’t construct individual P&L statements by franchise. Again, this is due to the lack of itemized SG&A expenses by the franchise.Conversely, if the subject dealership had recently acquired or added an additional franchise to its operations during the reviewed period, the value of that franchise should also be captured. If the franchise is recently acquired, information regarding the acquisition price and/or consideration paid for Blue Sky could be considered in the valuation analysis, especially if the operating results haven’t fully reflected the integration of the new franchise. Franchise value paid for acquisitions in historical periods can also be helpful information. For example, if a dealership acquired a particular franchise for a Blue Sky value of $10M but the dealership’s performance and earnings from that franchise had suffered in the years following the acquisition, the concluded value of that franchise might be lower today. In this example, the original $10M Blue Sky value for that franchise would have been helpful as a sanity check to the concluded value for that franchise today.ConclusionEntities owning multiple franchises pose unique challenges to valuation compared to a single-franchised dealership. While the conclusion of value for the entity is contained in a single value, we have discussed the importance of evaluating the individual value of the franchises involved or at least examining the concluded value in the context of the earnings and blue sky value inherent within each franchise.Contact a professional at Mercer Capital to discuss the value of your multi-franchised or single-franchised auto dealership.

2021 New Year's Resolutions for Auto Dealers

At the start of a new year, many people, including myself, try to establish resolutions to get the year started off on the right foot. This is especially prevalent this year with most people welcoming 2021 with open arms after the disaster of a year that was 2020. When considering the auto industry in 2020 and predictions for 2021, making some “resolutions” for your dealership to prepare for the year ahead could prove to be helpful. With that being said, here are a few common “New Year’s Resolutions” that can be applied to your auto dealership.Resolution #1 – Keep Up With the TimesAuto dealers that choose to embrace technology could find themselves faring better than those that don’t in an era of e-commerce explosion.As we have discussed previously, the COVID-19 pandemic has pushed auto dealers into the 21st century as they relied more on technology to reach their audience. In March 2020 as the pandemic was beginning, U.S. search interests in “dealerships near me” dropped more than 20% from the prior month. Furthermore, as stay-at-home orders swept across the country, many people could not visit dealerships even if they wanted to. In order to continue to reach customers, offering at least portions of the buying process online became necessary. As the year continued and the pandemic trudged on, consumers dramatically shifted their shopping habits to online, as e-commerce sales are projected to increase by 40.3% in 2020 from the prior year. For dealerships, specifically, 90% of car shoppers prefer a dealership where they can start the buying process online. Although dealerships most likely can’t and won’t reach the digital offering scale of a Carvana, having sleek offerings online is important.Now as we begin the new year, there is some evidence that consumers won’t revert to pre-COVID buying habits. A research paper from McKinsey in early 2020 said trends in China suggest that between three and six percentage points of market share gained by online channels will be "sticky." What does this mean for your dealership? With overall buying habits having shifted, consumers are going to be more familiar with the online purchasing process. Furthermore, experts anticipate the pandemic to continue into 2021. Making an effort to invest in digital technology for your dealership to reach customers could reap dividends as the year goes on.Resolution #2 - Invest in YourselfInvestment in facilities to achieve image compliance could lead to a bump in your dealership’s value.Despite fewer people visiting physical dealerships because of COVID, it could still be worthwhile to consider giving your dealership an upgrade in 2021. As reported in Kerrigan’s Q3 Blue Sky Report:“Image compliant dealerships with low rent command higher multiples. Up-to-date dealerships are more attractive to buyers because they require no additional investment. Dealers also command better pricing when they have an attractive rent factor, lowering fixed expenses. In our experience, dealers frequently own the real estate or hold it in a separate but related entity. But as dealers know, rent factors include other factors include utilities, property taxes, interest, and other hard costs of ownership. Dealerships that can reduce this expense or have a favorable lease if owned by an unrelated third party, stand to have higher earnings, and potentially a higher multiple with lower risk. In general, if a dealership is image compliant and its rent-to-gross profit is below 10%, it is considered to have low rent.”Resolution #3 - Shed Some PoundsAuto dealerships can benefit from becoming leaner and meaner by streamlining SG&A costs to promote a healthier bottom line.A prevalent 2020 trend was cutting SG&A costs. As we mentioned in our Q3 2020 earnings calls post, advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. This decrease in overall SG&A has helped support many auto dealer’s bottom lines as SAAR has been running below 2019 levels.Looking into 2021 and a continuing pandemic, improving the bottom line is going to continue to be important. Advertising costs can be alleviated by choosing alternative and more efficient channels such as social media, as we mentioned previously. Furthermore, with consumers doing more of the car shopping process online, personnel expenses that used to be necessary are no longer so. Auto dealers can take full advantage of this to streamline costs. While many of these costs have already been cut to the bone, dealers will need to be judicious about adding in costs. We had clients coming out of the Great Recession saying they ran leaner than they have previously thought was possible. Ten years of slow and steady economic growth may have led to excess expenses that naturally get trimmed in a downturn. Dealers need to determine which expenses can be removed and which may need to return in order to boost sales, particularly when new vehicle inventory becomes less tight.Resolution #4 - Make GainsWith vehicle manufacturing revving up, it could prove beneficial to offer consumers wider varieties of models.If you have been reading our blog over the course of the year, one of the big takeaways that we have been hammering home is that inventory shortages have plagued the industry all year due to lag from shutdowns. Dealers won’t have needed to read a single word we’ve written to know that for themselves. However, with plants back up and running, many dealerships are expecting inventory levels to normalize in 2021; therefore, there might be pent up consumer demand so dealerships will be working to get the right inventory. While consumers have been more patient in light of the pandemic, that patience won't last forever.As the pandemic continues on, many people are still wary of using public transportation and ride-sharing. In fact, a survey conducted by Google found that 93% of people say they are using personal vehicles more. Furthermore, a recent Cars.com survey reported that 20% of respondents who didn’t own their car were considering purchasing one. Dealerships in 2021 could continue to find new customers trying to shift from public transportation to a personal vehicle.ConclusionThe Auto Dealership team at Mercer Capital wishes you a happy and safe new year! If you have any questions about what your dealership may be worth, please feel free to reach out to us.

Weather Report for Auto Dealers

Q3 Climate for Blue Sky Multiples, Transaction Activity, and Other Trends

Ever wonder why the local news teases the weather report in the first five minutes of each broadcast before returning to it later in the show? Because everyone wants to know the weather forecast so they can plan ahead.In this post, we provide the weather report for the auto dealer industry with a review of the three recently released industry reviews.Haig Partners and Kerrigan Advisors have released their Third Quarter Blue Sky Reports and J.D. Power just released its U.S. Sales Satisfaction Index. These reports are timely and informative of not only where the auto dealer industry is today, but where it is headed.Transaction Volume Transaction volume often defines the health of the industry. After a turbulent spring and slow climb during the summer, auto dealer transactions are on the rise in the third quarter. According to Haig Partners, transactions for the third quarter topped 95, representing a 9% increase over the same quarter for 2019. As seen in the graph below, public auto dealers have capitalized on their increasing market values, acquiring 21 dealerships in Q3 compared to only 6 in Q3 2019. The monthly average number of dealerships being acquired is currently about 30, compared to 5 or fewer per month in April/May. [caption id="attachment_35044" align="aligncenter" width="277"]Source: Haig Partners[/caption] Kerrigan noted the increase in multi-dealership transactions. The much publicized acquisitions of luxury dealerships by Lithia Motors and Asbury Automotive was evidence of this trend. Other contributors include the formation of many special purpose acquisition companies (or SPACs) and investment companies, which we have previously written about. Many dealerships are on the back side of the family ownership life span, and high multiples are making exits more intriguing. Specifically, Kerrigan notes that multi-dealership transactions are up from 33 to 46, or an increase of 25% from the first nine months of 2019. Q3 2020 is tied for the second most multi-dealership transactions for the same time period in the past 5 years. [caption id="attachment_35054" align="alignnone" width="702"]Source: Kerrigan Advisors[/caption] ProfitabilityTwo weeks ago, we discussed the record level Gross Profit Margins per Unit (GPUs) in new and used vehicles and their contribution to the overall profitability of dealerships through October 2020. These metrics only tell part of the profitability story. Auto dealers have also been successfully minimizing their operating expenses during these unprecedented times and Haig points to three specific expense areas: advertising, labor, and floor plan.As we have discussed several times throughout the year, new vehicle supply has been constrained as manufacturing plants have faced temporary shutdowns and other challenges. Dealers have had fewer new vehicles to sell, and consequently, have chosen to spend less on advertising. This lower level of inventory has reduced the cost to maintain the inventory, or floor-plan interest. Lower interest rates have further lowered these costs. As a result, auto dealers’ floor plan costs are currently much less than in a normal operating environment.Finally, personnel or labor costs have been drastically reduced across many dealerships. The lack of foot traffic in showrooms and temporary shutdowns across the country have forced many auto dealers to reduce their staff. Kerrigan notes that few buyers they have spoken to expect dealers to return to pre-COVID staffing levels and are instead choosing to optimize digital sales platforms to help support operations with reduced staff.Blue Sky MultiplesSo far, 2020 has been the tale of three quarters in terms of Blue Sky multiples. Q1 saw a decline in virtually every brand covered by the Haig Report. While Q2 showed some recovery in Blue Sky multiples coinciding with a steady climb in SAAR, Haig has raised the Blue Sky multiple range for nearly every brand in Q3. The only brands not to see an increased rating by Haig for Q3, are Infiniti, Cadillac, and Lincoln. However, Haig has recently reported franchise value ranges for these brands in lieu of Blue Sky multiples for several quarters due to operational struggles.Kerrigan’s Blue Sky multiples have mostly been held steady in Q3 except for a reported increase in three brands: Chevrolet, Buick/GMC, and Volvo. The difference in perspective of these multiples can be explained in the pricing of transactions. With unparalleled profitability experienced by many auto dealers in 2020 due to increased GPUs and decreased operating expenses, buyers must ponder the sustainability of each of these measures, as well as overall profitability. Historically, according to Haig and Kerrigan, auto dealer transactions were often priced based upon the latest year’s earnings. Buyers now need to evaluate the expected level of earnings for the dealerships into the future, a metric that the auto dealer industry has never relied on much. According to Kerrigan, buyers are pricing transactions off of a modified/sustainable 2020 earnings stream. In other words, buyers are adjusting or discounting actual 2020 earnings from elevated levels to a future expectation.Similarly, Haig Partners discusses buyers' pricing transactions based on previous 2019 level of earnings, rather than the heightened/unsustainable 2020 levels.Sales Satisfaction IndexIn addition to transaction volume, profitability, and blue sky multiples, the Customer Service Index (CSI) and Sales Satisfaction Index (SSI) results provide another lens when considering auto dealership valuations. J.D. Power recently released its 2020 SSI report. The results for Luxury Brands are displayed below.[caption id="attachment_35040" align="alignnone" width="696"]Source: J.D. Power[/caption] It’s interesting to note that the three brands without a reported Blue Sky multiple from Haig (Lincoln, Cadillac, and Infiniti) all scored in the upper half of the results from the SSI for luxury brands. While SSI is clearly important, observing other factors is necessary when considering a brand’s overall perception and value proposition. Each of these three has struggled with some combination of aging models/inventory, introduction of new models, and entrance into the electric vehicle market. The results for the Mass Market Brands are as follows. [caption id="attachment_35043" align="alignnone" width="653"]Source: J.D. Power[/caption] Conclusion The current forecast for the auto dealer industry looks bright heading into 2021. Both Haig Partners and Kerrigan Advisors predict Blue Skies ahead for auto dealers, though dealers will certainly recall the rainy days of March and April. Even the successful private auto dealers that have been able to navigate the challenges of 2020 face decisions regarding the future of their dealerships.Conversations regarding profitability and expense levels and their sustainability are prevalent in all auto dealer valuation projects. Contact a professional at Mercer Capital to discuss these questions or to find out the value of your auto dealership.

November 2020 SAAR

SAAR Declined to 15.6 million, Primarily Driven by a Decline in the Number of Selling Days for the Month

After steady increases, SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) experienced its first notable decline since April, dropping to 15.6 million from 16.3 million in October. November 2020 is down by 8.4% compared to the same period in 2019, and through 11 months of the year, new light-vehicle sales are down 16.7% compared to the same period last year. The calendar differences are important to note for this month with November 2020 only having 23 selling days relative to 26 days in November 2019. As Thomas King, president of data and analytics division at JD Power notes:November 2020 is a prime example of why accounting for selling day differences is important in measuring comparable sales performance. After two consecutive months of year-over-year retail sales gains, a quirk in the November sales calendar will result in new-vehicle retail sales appearing to fall 12%. This year, November has three fewer selling days and one less selling weekend compared with 2019. When these calendar quirks are accounted for, new-vehicle retail sales are expected to almost match 2019 levels. While the sales results illustrate the continued strength of consumer demand, that strength is further reinforced by transaction prices hitting another record high, even as manufacturers and retailers continue to remain disciplined on new-vehicle incentives and discounts.While adjusting for calendar differences is important in determining true trends that are occurring in the industry, it is also necessary to consider retail SAAR vs. total SAAR.While retail SAAR includes the daily selling rate for retail auto sales to individual customers, total SAAR also includes fleet sales to businesses, government, and daily rental companies. Because of this distinction, considering just total SAAR alone may not indicate actual consumer purchase trends. This has been especially notable for this year as fleet vehicle sales and rental companies have been inordinately affected by the pandemic compared to auto dealer sales.Though dealerships experienced a decline when they had to shut down due to stay-at-home orders, business picked back up once they could reopen. Fleet sales, on the other hand, are suffering from changes in consumer trends due to the pandemic, rather than government mandates. For example, many businesses have adopted a work from home model to keep employees healthy during the pandemic. As such, rental car needs for business purposes have declined. Furthermore, overall travel, in general, is down as people have been wary to fly, further impacting this market. May was the toughest month with rental units declining 91%, and Hertz announcing their bankruptcy. From March through September 2020, fleet sales have seen an average monthly decline of 53% with November fairing slightly better with a 25% decline from the same time last year.Observing the implications numerically can be helpful to further illustrate this point. As you can see in the chart produced by JD Power, while total SAAR is down 7.6% (unadjusted for calendar dates), retail SAAR is only down 5.1% (also unadjusted). These numbers reflect the brunt of economic difficulty that fleet sales have faced relative to retail sales. An important note is that this graph is primarily for illustrative purposes with both of these SAAR numbers being predictive rather than actual. Average incentive spending per unit is expected to top $3,800, marking the third straight month of incentives below $4,000, which reflects strong vehicle demand supporting sales. The average new-vehicle retail transaction price in November is expected to reach a record $37,099, topping the previous record last month of $36,755. While tight inventory constraints have plagued the industry all year, there are signs that things are improving. According to Cox Automotive Senior Economist Charlie Chesbrough, “The tight inventory situation, where available products at dealerships were drawn down to very low levels, reached a peak in late summer. However, factory production has improved while sales pace has slowed, and the combination is allowing dealerships to replenish somewhat. Overall, supply still remains far below last year's levels, and holiday sales may slow if buyers can't find what they want." With factories now operating at pre-pandemic levels, production has not been the hurdle it was through mid-year. It is important to note potential tailwinds to SAAR going into the end of the year, specifically in terms of the COVID-19 pandemic and ongoing U.S. politics. As of writing this blog post, coronavirus cases are surging throughout the country as a result of colder weather and indoor gatherings to celebrate the holidays. With restrictions being put back in place throughout the country, dealerships may see less foot traffic as people try to limit exposure as much as possible. However, with promising news on the vaccine front in the past month, hopes are high that there may be a return to normalcy on the horizon. The political climate continues to pose challenges for auto dealerships as a new stimulus continues to be stuck in a divided Congress. Weekly unemployment claims might be starting to be affected by the lack of stimulus with more than 947,000 workers filing new claims for state unemployment benefits the first week of December. Applications have risen three times in the last four weeks and are up nearly a quarter of a million since the first week of November. This is evident when looking at the chart below produced by the New York Times.Conclusion While we think it’s far too early to suggest we might be falling into a second decline, the downturn in SAAR this month shows we are not yet out of this pandemic. An effective and distributable vaccine should boost economic activity and support employment figures and in turn boost consumer spending on items such as vehicles. However, we note that reduced business travel may have long-term impacts on rental businesses, and fleet sales may not return to pre-pandemic levels as a second order impact. We will continue to monitor these trends as I’m sure you and all of our auto dealer clients will.If you want to discuss how SAAR (total and retail) and the greater macroeconomic environment may impact your dealership, contact a member of the Mercer Capital Auto Dealer team today.

Measuring Up: Evaluating Your Auto Dealership Against Benchmark Metrics

In a strange year of oddities, 2020 has all of us constantly evaluating life’s basic truths. Market conditions vary drastically across all industries and even geographically within the same industry due to local government restrictions. It’s critical for auto dealers to continually analyze all aspects of their business and be ready to capitalize on industry trends. We previously discussed the use of the NADA dealership profiles as a useful tool to examine timely monthly data based on averages or dealership type. Three specific metrics in the data have reached their highest level since the data was originally published in 2012: new vehicle retail gross profit per unit, used vehicle retail gross profit per unit, and used-to-new vehicle unit ratio.Retail Gross Profit Per New VehicleThis metric considers numerous factors. The numerator is gross profit achieved on the retail sale of new vehicles and is measured by the retail selling price less the cost paid to the manufacturer for the dealership to acquire the vehicle. Industry professionals also often refer to this metric as "front-end margin" meaning front of the showroom and not including elements of fixed operations. The denominator is the total number of vehicles retailed, or new vehicles sold less fleet sales which, as we’ll discuss in a future post, is subject to different operating environments. Over time, auto dealers’ new vehicle gross margins have been compressed as a percentage of retail sales price as consumers have become more knowledgeable about manufacturer costs and sticker prices in the information age. Dealerships aim to create long-term value by placing more new vehicle units on the road in hopes of the continuing service revenue that results from miles driven. These fixed operations tend to be higher margin, which aids the overall gross margin of the dealership. Though as noted above, this is not captured in new vehicle gross margin.As of October 2020, retail gross profit per new vehicle or new vehicle gross profit per unit ("GPU") climbed to $2,355 for the average dealerships as defined by NADA. This eclipses a previous high of $2,226 achieved in 2012. The year-to-date figure represents a nearly $280/unit increase over the average figure of $2,076 from 2012 through 2019. The chart below displays the annual new vehicle gross margin from 2012 through the current year-to-date.Retail Gross Profit Per Used VehicleLike new vehicle GPU, this metric refers to the gross margin achieved on the retail sale of a used vehicle and is measured by the retail selling price less the cost paid to acquire the vehicle divided by total units retailed. Similar to the new vehicles retailed which excludes fleet sales, it should be noted that this metric refers to retail sales only and does not include used vehicles for wholesale. Like its new vehicle gross profit counterpart, this metric has also climbed to its highest point in the observed period, currently at $2,678 per unit. We have previously written about several factors driving this metric including the heightened performance of the used vehicle market in the pandemic due to production shortages and shipment delays for new vehicles as manufacturers have experienced partial shutdowns. Low supply leads to higher prices, and dealers have been able to capture their share of this margin. The year-to-date figure represents a nearly $300/unit increase over the average figure of $2,386 from 2012 through 2019. With rising profitability over lower volumes, it’s clear why this figure is reaching all-time highs. The chart below displays the annual used vehicle gross margin from 2012 through the current year-to-date.Used-to-New Vehicle Unit RatioWith near-record levels of gross profit per new and used vehicles, how has that affected the product mix of vehicles sold by dealerships? The used-to-new vehicle unit ratio measures the amount of used retail units divided by new retail units. This ratio or product mix held fairly stable from 2012 through 2018 ranging from approximately 75% - 80%. Over the last year and a half, this ratio has climbed to 84.8% at the end of 2019 and peaked at 96.3% for October 2020. Used vehicles have become more profitable and have been more available to dealers at times in 2020. This ratio has reached an almost 1:1 relationship. The figure below displays the annual used-to-new vehicle unit ratio from 2012 through the current year-to-date. There are elements of both supply and demand in this figure. As noted in the previous charts, dealers earn more gross profit per used vehicle retailed than new vehicles. That means dealers get more bang for their buck when the used-to-new ratio approaches 1:1. However, customers are historically attracted to franchised dealerships because they want a specific make or model. With the reduction in new vehicle supply, it appears dealers have effectively pivoted their customers from new vehicles to used vehicles rather than losing the sale when their preferred option isn’t in stock. Another factor is likely in play, however. While supply is shifting towards used, demand is as well. With spikes in unemployment this year and the uncertainty surrounding job security for many, consumers are less likely to be able to afford the higher sticker prices of new vehicles, substituting to used as a more reasonable alternative.Potential Impacts and ConclusionHow is your dealership measuring up to these metrics and what impact could they have on the value of your dealership? As always, comparison with industry data should be viewed with some caution as it may not pertain directly to your dealership or the economic conditions experienced in your area. Nonetheless, the levels of these three metrics reflect the auto dealer industry’s ability to adapt to the challenges of 2020.The more important question for these metrics and for the valuation of your dealership, is how sustainable are these metrics for the long-term? The historical graphical information for each suggests that these figures will revert back to previous levels at some point. A majority of our projects for litigation and corporate valuations involve evaluating the expected annual earnings of the dealership for the future. Often, we examine these various metrics and the overall profitability and performance of the dealership over a longer historical period of time than just the latest year to determine the sustainability and future expectation. Just like dealers wouldn’t want to sell their business after a down year, valuations can become too lofty if an outlier year is effectively forecasted as the new normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth, contact a professional at Mercer Capital to perform a valuation or analysis.

Valuation Assumptions Influence Auto Dealer Valuation Conclusions

How to Understand the Reasonableness of Individual Assumptions and Conclusions

There are several life events (large and small) that require an owner of an auto dealership to seek a business valuation – estate planning, a potential sale, shareholder dispute/litigation, divorce, death of an owner, etc. Often the owner of the dealership and their advisors may only view a handful of business valuations during their careers. It is not unusual for the valuation conclusions of appraisers to differ significantly, with one significantly lower or higher than the other.Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.What is an owner or their advisor to think when significantly different valuation conclusions are present? The answer to the reasonableness of the conclusion lies in the reasonableness of the appraiser’s assumptions. However, valuation is more than “proving” that each and every assumption is reasonable. Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.A short example will illustrate this point and then we can address the issue of individual assumptions. In the following example, we see three potential discount rates and resulting price/earnings (“P/E”) multiples. The discount rate or rate of return is a key component in determining the value of an auto dealership under an income approach. While other methods, including Blue Sky multiples are more often used, determining the rate of return applicable to an auto dealership is also an important step in a business valuation.In the table below, we look at the theoretical assumptions used by appraisers to “build” discount rates. We show differing assumptions regarding four of the components, and none of the differing assumptions seems to be too far from the others. So, we vary what is called the equity risk premium (“ERP”), the beta statistic, which is a measure of riskiness, the small stock premium (“SSP”), and specific company risk (“SCR”).The left column (showing the low discount rate of 12.0% and a high P/E multiple of 11.1x) would yield the highest valuation conclusion. The right column (showing the high discount rate of 23.5% and the low P/E of 4.9x) would yield a substantially lower conclusion. That range is substantial and results in widely differing conclusions.In either case, appraisers might have made a seemingly convincing argument that each of their assumptions were reasonable and, therefore, that their conclusions were reasonable. However, the proof is in the pudding. Perhaps, neither the low nor the high examples would yield reasonable conclusions when viewed in light of available market evidence of the particular franchise, and location and profitability of the subject dealership.So, as we discuss how to understand the reasonableness of individual valuation assumptions in business appraisals of auto dealerships, know also that the valuation conclusions must themselves be proven to be reasonable. That’s why we place a “test of reasonableness” in every Mercer Capital valuation report that reaches a valuation conclusion.Auto Dealership Valuation AssumptionsNow, we turn to individual assumptions utilized in an auto dealership valuation.Growth RatesGrowth rates can impact a valuation in several ways. First, growth rates can explain historical or future changes in revenues, earnings, profitability, etc. A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.Growth rates, as a measure of historical or future change in performance, should be explained by the events that have occurred or are expected to occur. In other words, an appraiser should be able to explain the specific events that led to a certain growth rate, in terms of total and departmental revenue and profitability. Auto dealerships experiencing large growth rates from one year to the next should be able to explain the trends that led to the large changes, whether it is new customers, new vehicle models being offered, loss/additional of a competitor, or other pertinent factors. Large growth rates for an extended period of time should always be questioned by the appraiser as to their sustainability at those heightened levels. This is particularly true for auto dealers, which as dealer principals know, experience ebbs and flows of the business cycle.A long-term growth rate is an assumption utilized by all appraisers in a capitalization rate. The long-term growth rate should estimate the annual, sustainable growth that the dealership expects to achieve. Typically, this assumption is based on a long-term inflation factor plus/minus a few percentage points. Be mindful of any very small, negative, or large long-term growth rate assumptions. If confronted with one, what are the specific reasons for those extreme assumptions?AnnualizationIn the course of a business valuation, appraisers normally examine the financial performance of the auto dealership for a historical period of around five years, if available. Since business valuations are point-in-time estimates, the date of the valuation may not always coincide with the auto dealership’s annual reporting period.Dealerships should be able to provide factory financial statements for the year-to-date period coinciding with the valuation date for the current and preceding year. A business appraiser can compile a trailing twelve month (“TTM”) financial statement from those two interim factory statements and the most recent 13th month year-end factory statement. A TTM financial statement allows an appraiser to examine a full-year business cycle and is not as influenced by seasonality or cyclicality of operations and performance during partial fiscal years. The balance sheet may still reflect some seasonality or cyclicality.Be cautious of appraisers that annualize a short portion of a fiscal year to estimate an annual result. This practice could result in inflating or deflating expected results if there is significant seasonality or cyclicality present. At the very least, the annualized results should be compared with historical and expected future results in terms of implied margins and growth.Dealer principals are well aware of monthly volumes of light vehicles sold in the U.S. that are annualized and referred to as “SAAR.” Due to the number of selling days and the inherent seasonality throughout the calendar year, properly determining the TTM financials should reduce the need to consider a complex formula such as that employed in the calculation of SAAR that almost certainly is not used if an appraiser simply annualizes by scaling up a stub period to 12 months.Litigation Recession “Litigation recession” is a term to describe a phenomenon that sometimes occurs when an owner portrays doom and gloom in their industry and for the current and future financial performance of the dealership. As with other assumptions, an appraiser should not blindly accept this outlook.A quality appraiser will compare the performance of the dealership against its historical trends, future outlook, and the condition of the industry and economy, among other factors. Be cautious of an appraisal where the current year or ongoing expectations are substantially lower, or higher for that matter, than historical performance without a tangible explanation as to why.Industry Conditions Most formal business valuations should include a narrative describing the current and expected future conditions of the auto dealer industry. An important discussion is how those factors specifically affect the dealership being valued. There could be reasons why the dealership’s market is experiencing things differently than the national industry. Industry conditions can provide qualitative reasons why and how the quantitative numbers for the dealership are changing. Look carefully at business valuations that do not discuss industry conditions or those where the industry conditions are contrary to the dealership’s trends. Current valuations in 2020 should include a discussion of the local industry conditions and their impact on a dealership’s performance as the effects of the pandemic have varied across states and regions.Valuation Techniques Specific to the Auto Dealer IndustryAs we have previously written, the valuation methods utilized in the auto dealer industry are unique and include an asset-based approach, an income approach, and a modified market approach incorporating concepts of Blue Sky value. It may be difficult for a layperson reviewing a business valuation to know whether the methods employed are general or industry-specific techniques. An auto dealer or their advisor should ask the appraiser how much experience they have performing valuations in the auto dealer industry.Risk Factors Risk factors are all of the qualitative and quantitative factors that affect the expected future performance of the auto dealership. Simply put, a business valuation combines the expected financial performance of the dealership (earnings and growth) and its risk factors. Risk factors show up as part of the discount rate utilized in the income approach of the business valuation.Like growth rates, there is no textbook that lists the appropriate risk factors for the auto dealer industry. However, there is a reasonable range for this assumption.Be careful of appraisers that have an extreme figure for risk factors. Make sure there is a clear explanation for the lowered or heightened risk. Otherwise, this is an easy area to influence a lower or higher valuation of the dealership.Blue Sky Multiples Another typical component of an auto dealer valuation is the use of Blue Sky multiples and the reflection of the concluded value as a measure of Blue Sky. As we have discussed, there are several national business brokers that publish these multiples quarterly by the manufacturer. Be wary of appraisers that do not reference Blue Sky multiples or explain their concluded values as a measure of Blue Sky. Also, be wary of appraisers that apply Blue Sky multiples to used vehicles or other metrics that are not widely recognized by the auto dealer industry.Another critique could be the range of Blue Sky multiples examined and how they are applied to the subject dealership. Take note of an appraiser that applies the extreme bottom or top end of the range of multiples, or perhaps even a multiple not in the range. Be prepared to discuss the multiple selected or implied and how the dealership compares to the range of multiples in terms of the local market (location and urban vs. rural), level of competition, historical profitability, etc.... we believe Blue Sky multiples are very helpful, at least for explaining value.In our review of appraisals performed by other firms, particularly those without considerable auto dealer experience, we see Blue Sky multiples either won’t be rigorously analyzed or may not even be mentioned. While this may not be a red flag to a layperson, we believe Blue Sky multiples are very helpful, at least for explaining value. To confirm the reasonableness of an appraisal that does not mention Blue Sky multiples, dealer principals can calculate it themselves. Blue Sky value is measured/calculated as the excess equity value over the tangible net assets of the dealership. If the implied multiple from an appraisal is unreasonable in the context of multiples seen for the relevant franchise(s), the overall reasonableness of the conclusion should be questioned.Time Periods Considered Earlier we stated that a typical appraiser examines the prior five years of the dealership’s financial performance, if available. Be cautious of appraisers that simply choose to use a small sample size, i.e. the latest year’s results, as an estimate of the dealership’s ongoing earnings potential. The number of years examined should be discussed and an explanation as to why certain years were considered or not considered should be offered.Some industries, like the auto dealer industry, have multi-year cycles, not just annually (further evidence of the importance of a discussion of industry conditions and consideration of recognized industry-specific techniques in the appraisal).The examination of one year or a few years (instead of five years) can result in a much higher or lower valuation conclusion. If this is the case, it should be explained.ConclusionBusiness valuations of auto dealerships are a technical analysis of methodologies used to arrive at a conclusion of value for the subject dealership. It can be difficult for an auto dealer or their advisors to understand the impact of certain individual assumptions and whether or not those assumptions are reasonable. In addition to a review of individual assumptions, the valuation conclusion should be reasonable.Mercer Capital performs numerous business valuations of auto dealers annually for a variety of purposes. Contact a professional at Mercer Capital to discuss your next business valuation.

October 2020 SAAR

October lightweight vehicle sales had their second month in a row above 16 million, coming in at an annualized rate of 16.2 million for the month. Though this is down 0.6% from the September SAAR of 16.3 units, it is still a positive sign for the industry that sales have shown notable improvement since the start of the pandemic. As Thomas King, president of data and analytics at J.D. Power noted:“Two consecutive months of year-over-year retail sales increases demonstrates that consumer demand is showing remarkable strength. The strong sales pace is occurring despite tight inventories. The combination of strong demand and lean inventories is enabling manufacturers to reduce new-vehicle incentives and is allowing retailers to reduce the discounts they typically offer on new vehicles.”SAAR for October 2020 is off by 3% from that of October 2019. Light trucks are continuing to bolster sales, coming in at 77% of new vehicles sold in October and 76% of new vehicles sold this year.The average new vehicle turnover from lots to consumers has fallen to 49 days, the first time it has fallen below 50 days in more eight years. 20% of vehicles are being sold after being on a dealer lot for only five days or less.As we mentioned in our Q3 earnings call blog post, public auto dealers noted how vehicle demand has been outstripping supply as manufacturers struggle to get new vehicles to dealers. Among the major public dealerships, there is consensus that this inventory shortage will continue through year-end before beginning to normalize in 2021. However, tighter inventory has contributed to higher gross margins and higher selling prices. In October, these prices are expected to reach another all-time high, rising 7.3% from last year to $36,755. More expensive trucks and SUVs have been drivers of this average transaction increase.Looking toward the rest of the year, not much is anticipated to change unless there is an unexpected relief to the inventory constraints. The sales calendar for November 2020 is shorter than that of 2019 (28 days in 2020 vs. 32 in 2019), so slightly deflated SAAR is expected.Dealership Valuations Looking UpWhen considering the year that auto dealerships have experienced, an outside observer would likely assume that dealership values are down. However, more dealerships are bullish on their valuations over the next twelve months according to a Kerrigan Advisors survey of dealers. The second annual survey found that 33% of dealers expect the value of their stores to rise in the next year, up from 26% in 2019. Another 53% expect values to remain the same, while 14% think their values will be lower. This is a change from 2019 where 60% expected values to remain the same and 14% to expect a decrease. Erin Kerrigan, managing director of the firm, noted "The rebound in auto sales coupled with reduced dealership expenses and higher vehicle margins will result in record industry earnings in 2020.” As seen in the table above, Subaru, Toyota, Porsche, Honda, and Mercedes-Benz have the highest expected valuation gains. These trends are in line with Blue Sky multiple increases as well, as Subaru’s blue sky multiple has seen an increase to 5.0x – 6.0x, while dealerships such as Infiniti and Cadillac continue to be below blue sky multiple levels. Some CaveatsThough dealers being bullish on their valuations is a good sign in terms of the recovery of the industry, every dealership is different. While there are many factors that need to be considered when determining the value of a dealership, here are three that are critical, especially when considering the operating in a pandemic.LocationWhile 38% of Subaru dealerships surveyed anticipate valuation growth this year, that percentage is unlikely to be consistent across the country.When determining the value of a dealership, it’s important to consider the local economy where the dealership operates, especially considering stay-at-home orders and business restrictions stemming from the pandemic.In March and April, dealers in the northeast were harder hit by the stay-at-home orders than the dealerships elsewhere. As of today, with the virus surging across the country, looking at the impacts in each specific region is important to determining dealership values.SalesWhile many dealerships are seeing earnings growth in Q2 and Q3, what is the quality of that earnings growth and how do dealerships’ earnings compare to that of prior years?If earnings have only increased due to operation cuts, that growth should be scrutinized a bit. Cutting costs can improve the bottom line in the short run, but it may not contribute to overall company growth over the long-term. We’ve had clients remark how the Great Recession taught them just how lean they could operate. Since then it’s likely that dealers have added back some expenses but the pandemic has again forced cost cutting. The sustainability of earnings in 2020 will depend on how many of those expenses can continue to stay low and how gross profits look once inventories become less scarce.Earnings growth must also be evaluated in the context of pre-pandemic levels, not just improvement from the bottom. The recent pattern in GDP growth is a good example of this. In Q3, GDP increased an impressive 33.1%, after having fallen 31.4% in Q2. While 33.1% is greater than 31.4%, we can see in the graph below that GDP has not fully recovered.OperationsIn an increasingly technological environment due to the pandemic, a dealership’s digital presence can contribute to their overall valuation. A dealership that has invested in their digital offerings has set themselves on a platform for growth.ConclusionThe valuation outlook for many dealerships is positive but dealerships are not created equal. The individual characteristics and performance of each dealership has to be analyzed in any valuation process.Feel free to reach out to us for more information about how current economic conditions may affect your dealership’s valuation or to discuss a specific valuation need in confidence.

Q3 2020 Earnings Calls

Low Supply and SG&A Reductions Lead to Record Earnings

Third quarter earnings calls started with an optimistic tone, with just about every call reporting record earnings despite revenue headwinds. Advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. Tight inventories continue to plague new vehicle volumes, which isn’t expected to get better until the turn of the year. To compensate for this volume decline, dealers have strategically priced the models they did have in stock. Executives noted some points in the quarter where certain models were completely out of stock. Trucks and crossovers have been particularly hot, representing over 75% of vehicles sold.Speaking of crossovers, many executives discussed the point of the transaction where consumers cross over from digital to in-person. During significant shelter-in-place restrictions that caused April lows, dealers were thrust into their online strategies and there were many prognostications about the potential long-term impacts. As the pandemic has persisted, consumers appear to have indicated a preference to beginning the process online, but the desire to test drive the vehicle or discuss the financing has limited the amount of fully online transactions.While Carvana is the new kid on the block in terms of public auto retailing, it’s their used-online operations that franchised dealers are looking to mirror. Across many calls, Carvana’s name was invoked as the key comparative tool to measure how digital offerings match up. While executives all project confidence about their used platforms, it appears clear that the well capitalized online used retailer has an advantage in this area. Still, franchised dealers have their own advantages with access to new vehicles and fixed operations.With consumers still spending a significant amount of time in their homes, the collision business has seen an impact as miles driven has decreased. While miles driven would appear to be the most direct indication of demand for autos, interestingly, executives have noted another trend. With the decrease in rental business and ridesharing, it looks like auto retailing may be regaining market share, which would benefit the industry if this trend continues as the number of miles driven rebounds.The recent Hummer EV unveiling also drew the attention of analysts and executives. The consensus was the hype surrounding the relaunch of a brand that was defunct since the financial crisis was a positive sign for GM, and the shift to electrification will continue. However, many noted the importance of quality models in this shift as consumers won’t be willing to pay up for vehicles (or expensive batteries) that don’t stand up on their own just because they’re electric. This is particularly true with low prevailing fuel costs. While the Hummer EV’s price point allows for good margins, it means volumes will be much lower and ultimately will have less of an impact on dealership profitability.Theme 1:Dealers made significant investments in digital offerings to compete under strict stay-at-home orders. As the pandemic persists, executives believe digital will continue to play a role particularly at the beginning of the shopping experience, though it is unlikely car buying moves fully online.[I]n this day and age 95% of the people are looking online first. – David Hult, CEO, Asbury Automotive Group[I]f a consumer wants to, which is less than 2% of the population right now[,] they can go online, buy a car from end-to-end, no touchpoints […] I think about 15% to 16%, 17% of our customer base right now is completing some percentage of the transaction online before they come to the store to pick it up. […] The consumers are telling us that they want to be able to search our inventory online, but they want to come to a store, sit with an associate that’s got experience dealing with the car that they’re looking at. They want to test drive from a big inventory before they buy a car and make that decision. Our goal in our hybrid approach from A to Z is to allow them, if they want to go A to J or they want to go A to Z, our system is going to allow that to happen. – Jeff Dyke, President, Sonic AutomotiveAbout 80% of our consumers use digital forms in some way during the process. We actually only sell about 1.5% of our cars today on a truly digital end-to-end type of solution. – Bryan DeBoer, President, and CEO, Lithia MotorsTheme 2:Demand continues to outstrip supply as manufacturers struggle to get new vehicles to dealers. Consensus appears to be 2021 before this begins to normalize. Tight inventories have led to higher gross margins.We’ve had of course running conversations with the manufacturers since the spring, and every target has been missed. What we’ve been told we would be shipped, it simply did not happen. I don’t see any change in the fourth quarter from what I understand is coming through, and so now we’re into the first quarter, best case. When I see that they’re able to consistently achieve their shipping targets, then we can talk about what you can sell new. The demand is there at retail. I’m not worried about the demand. […] we’ll either get it through the volume or we’ll get it through pricing. – Mike Jackson, Chairman & CEO, AutoNationAvailability is coming back. I think we’ve got or 1,000 or 1,200 more cars on the ground at this point than we did last month at this time. And that just keeps improving every month. Manufacturing is doing a great job getting inventory back in our hands. The demand is there, and I think we’ll all be back and rolling as we move into the first and second quarter of next year as supplies build. From a used car perspective, […] the supply is endless. – Jeff Dyke, President, Sonic AutomotiveThe substantial improvements in gross profit of over $1,000 per unit compared to third quarter of 2019 are largely attributed to high level of incentives from our OEM partners and a perceived inventory shortage in the country. –Bryan DeBoer, Presiden, and CEO, Lithia MotorsOperators are very savvy, when they cannot replace a vehicle. They don't sell it as cheaply. I mean, that's the simple thing. They know whether they can trade with another dealer, and if they can replace it. So that's driving these high margins throughout the industry. And the ramp up in supply from the OEMs has been far below what anyone in our sector would have expected. We're just now starting to receive a few more vehicles and we're retailing every month. But our new vehicle inventory year-over-year, one point drop something like 12,000 units. So we were still nowhere near back to normal levels. And I'm sure, we're not the only one. So while the reduction in margins going forward will be proportionate to the increase in inventory, there still appears to be a long way to go before the industry is back to normal move vehicle and inventory levels. – Earl Hesterberg, President and CEO, Group 1 AutomotiveAs we sit here today that we’re still benefitting in our GPUs from the lower inventory and we anticipate at this point to benefit throughout the quarter. The virus is starting to heat, but backed up as we all know, assuming factories don't shut down at all, we anticipated some point in the first quarter to get inventory levels somewhat back to normal, and at that point you would assume you would feel it into margins, but we don’t see that happening in Q4. – David Hult, CEO, Asbury Automotive GroupTheme 3:While working from home has led to a decline in miles driven which has negatively impacted collision, other areas of parts and service have come back. Despite fewer miles driven, some executives also believe there is a structural change in demand wherein consumers want their own vehicles.In our products and service numbers that we disclosed collisions in there. Collision for us is running, for 12% to 15%, back, depending upon the market. So that's pulling back our CP numbers. We've been positive for the last few months in service specifically, as it relates to customer pay in warranty. – David Hult, CEO, Asbury Automotive GroupI think we got to think a little bit socially what's really happening, with a vehicle market and personal mobility. […] Personal mobility […] should create some more demand and use cars and also new cars now, not high luxury cars. But I mean, cars that we would use on a daily basis if you needed transportation, because I think combined transportation where two or three people are together, whether it's in a transit, public transit, whether it's a rental car, whether it's Uber or Lyft, I think there's some softness in those businesses, which will drive more automotive sales for us both in new and used. So I think these are things that personal use, will be help us drive a bigger part of the share of the auto business in the future. And I could be wrong. But there's definitely a flight to safety. – Roger Penske, Chairman & CEO, Penske Automotive GroupThere has been a significant shift towards individual mobility as a result of the pandemic and shelter-in-place. This has increased demand across the board from pre-owned through new in every segment. This individual retail demand is lasting and will continue for the next several years. – Mike Jackson, Chairman & CEO, AutoNationConclusionAt 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. 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.

GM and Nikola Partnership: What Went Wrong and Where Does it Stand?

Even with Halloween, we doubt your weekend was as scary as the past few months have been for Nikola...As we have discussed previously, electric vehicles (EVs) are all the rage with new start-ups trying to capture a slice of the pie that Tesla has been helping grow for years. In response, traditional manufacturers have begun to create EV options of their own. However, the entry path into the EV space has its drawbacks. For start-ups entering the industry, they may have the technology or innovative idea but lack the scale and access to capital necessary to gain market share and keep up with established competitors. Legacy manufacturers face the opposite problem: while they have the scale and capital, diverting resources into R&D for electric in a rapidly progressing space can lead to minimal tangible gain while it’s established products languish. To solve this mismatch, a new trend has emerged as manufacturers seek start-ups for their technology in a mutually beneficial relationship, perhaps best exemplified by GM and Nikola’s plan for a partnership. In this post, we look at the original deal, ensuing issues, and current plans. We will also look at what this trend could mean for dealerships going forward, and the importance of the valuation date.The Initial DealIn early September, Nikola stock got a massive boost after announcing a partnership with General Motors. Under the agreement, GM would engineer and build Nikola’s pickup truck named the Badger. In return, GM would take an 11% stake in Nikola and have rights to nominate one person on the board of the startup. This $2 billion equity stake won’t be in the form of cash however, but instead will be in “in-kind” contributions. These contributions include access to General Motors’ global safety-tested and validated parts and components. In regards to the deal, Nikola Founder and Executive Chairman Trevor Milton had this to say:Nikola is one of the most innovative companies in the world. General Motors is one of the top engineering and manufacturing companies in the world. You couldn’t dream of a better partnership than this […]. By joining together, we get access to their validated parts for all of our programs, General Motors’ Ultium battery technology and a multi-billion dollar fuel cell program ready for production. Nikola immediately gets decades of supplier and manufacturing knowledge, validated and tested production-ready EV propulsion, world-class engineering and investor confidence. Most importantly, General Motors has a vested interest to see Nikola succeed. We made three promises to our stakeholders and have now fulfilled two out of three promises ahead of schedule. What an exciting announcement.General Motors Chairman and CEO Mary Barra shared similar sentiments about the deal:This strategic partnership with Nikola, an industry leading disrupter, continues the broader deployment of General Motors’ all-new Ultium battery and Hydrotec fuel cell systems […]. We are growing our presence in multiple high-volume EV segments while building scale to lower battery and fuel cell costs and increase profitability. In addition, applying General Motors’ electrified technology solutions to the heavy-duty class of commercial vehicles is another important step in fulfilling our vision of a zero-emissions future.While Nikola would utilize GM’s fuel cell technology for the Badger, they would still be responsible for the sales and marketing, and the Badger would remain under the Nikola brand name. Though the Badger was first announced on February 10, 2020, production was not expected to occur until late 2022.What Went Wrong?Although the deal was initially anticipated to close on September 30, 2020, Nikola experienced troubles over the weeks prior that led to delays as their value has dropped sharply. Behind this decline in value and trouble sorting out the deal is a litany of allegations. Things began to fall apart just two days after the announcement when short-seller Hindenburg Research released a study claiming Nikola was based on “intricate fraud built on dozens of lies.” Included in these fraudulent claims is an allegation of Nikola staging a 2018 video of its hydrogen fuel-cell truck driving. Hindenburg alleges that the semi-truck was not actually driving, but instead, rolling down a long gentle slope. In response, Nikola stated it never claimed that the car was propelling itself. They also noted the careful wording employed at the time of the vehicle “being in motion” did not necessarily indicate that it was moving on its own accord. This technicality didn’t do much to assuage investors.Another misrepresentation that was alleged is Nikola’s efforts to develop a new kind of battery for use in electric vehicles. In November 2019, Milton claimed that Nikola would unveil “the biggest advancement we have seen in the battery world,” with these claims based on the planned acquisition of ZapGo. However, the acquisition never went through after Nikola stated that ZapGo had nothing more than interesting research with no ability to commercialize it. Despite pulling out of the deal, Nikola’s message about the new advancement in battery technology remained the same, putting into question if there is actually this battery technology in the works at all. This was not the only problem for Nikola in the past month, however, as the Department of Justice and SEC are reportedly probing Hindenburg’s allegations and two women in Utah filed sexual abuse charges against Milton. Ultimately, all of this culminated into a mountain of insurmountable issues for Trevor Milton, who resigned from his position as Executive Chairman of Nikola on September 20th. Post resignation, Nikola stock dropped 17% to $28.35 after already being down almost 27%. As of November 2nd, Nikola’s stock price stood at $18.84. This is a 76.4% decline from the stock’s peak as of June 9th and down 62.3% since the GM announcement spike.What Now?With all of this being said, it’s clear why GM and Nikola haven’t been able to close their $2 billion deal. The question now seems to be under what terms a “new deal” may come, or if there should even be a deal at all. According to several sources, GM is considering revisions to the deal and may seek a higher stake in the startup after its valuation fell due to the allegations. Though there are some new considerations that need to come into play for the deal to occur, some analysts see it still as a viable possibility. J.P Morgan analyst Paul Coster thinks that a new deal could be signed by early December, as he notes, “Nikola needs access to GM’s supply-chain, engineering resource, the Ultium battery, and Hydrotec fuel cells to de-risk the Class 8 truck initiative.” The analyst wrote in a Monday research report, “GM needs to realize a return on billions of dollars of investment in hydrogen fuel cells, and Nikola might be the best available option." He believes that the price target for Nikola is still around that $41 September value and that the stock is currently undervalued. However, with the December 3rd deadline of renegotiations looming, November is going to be critical to getting something put together.TakeawaysThough the GM and Nikola deal is in limbo, we believe more partnerships like this may materialize in the future. With increased emphasis on energy-efficient vehicles going forward, traditional manufacturers are going to need to find ways to meet consumer demand and fuel efficiency regulations. Furthermore, the looming election and the potential for a leadership transition might pave the way for EVs to carve out a more significant spot in the market (if you haven't already, read our blog post on Trump and Biden’s potential policy impacts on the auto industry). Manufacturers may seek partnerships and acquisitions in lieu of creating their own electric vehicle technology. Ultimately, only time will tell, but the struggles of GM and Nikola to close this deal might not be a reflection that these deals are doomed, and instead, a hiccup before other auto manufacturers try to create their own deals with EV start-ups.This GM and Nikola deal sheds light not only on the current EV industry, but also on how important the valuation date is in determining value for deals such as this. In the initial deal, Nikola was going to give 47,698,545 shares of its common stock to GM Holdings in exchange for in-kind contributions. These shares were valued at $2 billion based on the average price per share of $41.93 as of the September 8th Nikola filing with the SEC. When considering this, does it make sense for GM to assume $41 per share, established at the September valuation date, when allegations have led to scrutiny of this number? Especially when the public market has reacted and the stock price has plummeted to under $20 per share? Your answer is most likely no. They should try to get a new valuation closer to the deal close date in order to more accurately determine Nikola’s current value.The same considerations should be made if you are considering buying and selling an auto dealership. Though it can be more difficult to determine value without the assistance of the public market as in the case of Nikola, there are still certain signs that a previous valuation may no longer be applicable. The most common this year has been due to the economic volatility of the COVID-19 pandemic and the ensuing recession. Because of these factors, the fair value of a dealership has most likely fluctuated depending on how they were able to navigate the past year. Proceeding with a deal considering a February valuation could lead to one party paying unfairly. With this being said, due diligence in regard to having a proper and timely valuation is critical to making sure that a buyer and seller both agree to a fair price.If you are interested in how the past year may have affected the value of your dealership, feel free to reach out to us.

Analyzing Sources of Peer Information for Auto Dealers

Data Drill Down

In our quarterly newsletters, we use various data sources to keep tabs on the auto dealer industry. This includes items like SAAR to gauge the health and activity of the industry in terms of volumes. In this post, we discuss other metrics that help us analyze the dealerships we’re engaged to value. The goal of analyzing such metrics is two-fold: we seek to contextualize how the company’s performance compares to peers and whether a dealership is likely to get a higher multiple in the marketplace. We also strive to provide our clients with an in-depth analysis that can be beneficial to the management of their dealership. Understanding value drivers and performance relative to peers helps dealers understand and, hopefully, increase the value of their business. While sources like RMA (defined below) are frequently used in valuations across industries as a starting point, the auto dealer industry has the luxury of having other unique data sources that can provide further insight to our clients. Let’s peel back the onion and drill down into these various data sources.RMA Annual Statement StudiesBeginning on the outer layer of our proverbial onion, one of the base resources employed by appraisers for companies in a variety of industries is the Annual Statement Studies: Financial Ratio Benchmarks, as published by the Risk Management Association. We refer to this information simply as “RMA” for short.This annual study allows users to determine the composition of common sized balance sheets, income statements, and other key financial ratios. Though RMA data was initially published to aid banks in determining the suitability of loans, this information is still helpful in the valuation context because it allows us to gain insight into industry financial trends.RMA data is offered by North American Industry Classification System codes (“NAICS” codes). For auto dealers, there are Retail – New Car Dealers (#441110) and Retail – Used Car Dealers (#441120). As seen in the pictures below, the vast majority of peer information comes from new vehicle dealers with over $25 million in sales. Most auto dealers, whether they have one rooftop or several, tend to fall into the over $25 million category. In an industry where vehicles retail around $30 thousand, a dealer only needs to sell about 830 vehicles a year to get to $25 million in revenue, and this doesn’t even consider fleet, wholesale, and fixed operations.While we frequently show both new and used vehicle financial ratios from RMA, the data from new dealers is more likely to be appropriate for a typical franchised dealer, even those with material used vehicle operations.As alluded to previously, this data provides common size balance sheet and income statements. For example, RMA data shows inventory comprises about 60% of total assets, while short-term notes payable (the vast majority of which for auto dealers is floor-plant debt) comprise about 52.8%. Many dealers do not fully finance their used vehicles, which likely plays a role in inventory exceeding short-term notes payable in the RMA data. Inventory as a percentage of total assets and inventory turnover can also be used to determine the amount of inventory held by a dealer.These data points can then be applied to the subject company we are valuing to consider how floor plan debt usage may impact liquidity and expenses and whether they are carrying adequate inventory to support sales.RMA data also provides helpful insights into the following metrics:Working capital as a percentage of salesInventory turnoverAverage Days Outstanding (on receivables and payables)Gross and Pre-Tax profit marginsOfficer/director compensation as a % of sales While these metrics are helpful in analyzing dealers, it is critical to use caution when relying on this information. We believe the data works better as a starting place, as the average of 2,000 dealerships is not going to be directly comparable to the dealership in question. Therefore, we find it more helpful as a test of reasonableness than some figure to specifically tether analysis.NADA Dealership Financial ProfilesWhile RMA data is a useful starting point, the auto dealer industry has more directly comparable data available. Peeling back the next layer of the onion, The National Automobile Dealers Association (“NADA”) publishes Dealership Financial Profiles on a monthly basis.Like RMA, data from all types of dealerships is compiled in the “Average Dealership Profile.” For dealers with many rooftops, this may give a good overall perspective. However, when valuing a single point location, Dealership Financial Profiles help us to get even more specific.NADA offers data for domestic, import, luxury, and mass market dealerships. This is helpful because while operations can be substantially similar for different brands of dealerships, margins and profit drivers tend to be different for the various types of dealerships. This enhanced granularity allows for better comparisons than the information provided by RMA, and monthly information is also more helpful than annual studies. However, NADA information focuses primarily on the income statement, with minimal information on the balance sheet available (excluding the net debt-to-equity and current ratio). Sales, gross profit, operating profit, pre-tax profit figures are offered for various types of dealerships as seen below for domestic dealerships. Beyond just margins, NADA data drills down further into the following: Profitability by department (new, used, and fixed operations)New and used retail volumesF&I penetrationAdvertising, rent, floor-plan interest, and SG&A expenses Like the RMA data, strict comparisons should be made with caution. Still, these are very helpful data points that can lead to better discussions with dealer principals, both about the performance of the business and potential normalization adjustments for valuation purposes. For example, dealerships frequently rent their facilities from an entity that owns the property. This entity and the dealership operations frequently have overlapping ownership structures, and this provides another data point to help determine if the company is paying a fair market-based rent. Related parties may also perform certain advertising functions, which by nature have fewer data points to determine whether a company is overpaying or underpaying for these services. As we mentioned above, another advantage of NADA data is the frequency of publication. Monthly information may be subject to seasonal quirks if profitability is stronger during certain months but comparing to prior year periods largely neutralizes this impact. Using more current information is particularly helpful in the dynamic environment we’ve experienced in this pandemic. For example, in the above figure, revenues and gross profit were down for the average dealership through August 2020, but pre-tax profits actually rose as expenses declined more than gross profit. This analysis would not be possible until the following year of RMA studies. Ultimately, NADA data gets to closer comparisons than RMA, but we can still peel back another layer.20 Group DataIn our valuation engagements, we frequently ask for 20 Group data, which is compiled by OEMs and compares dealers to their peers.Unlike NADA data, the peers in a 20 Group statement will be only the same brand, and selected peers will likely be more similar to the subject company in terms of size or geography (or both). As such, this represents the closest comparison possible.Unfortunately, this data is not always available, and as noted in our other sources, we caution against heavy reliance on such information as necessary valuation adjustments are not frequently considered on dealer financial statements, and therefore, will not lead to fool-proof data points upon which to base valuation adjustments.Blue Sky Transactions DataAnother data source frequently considered in transactions of auto dealerships are Blue Sky multiples, as published by Haig Partners and Kerrigan Advisors.Blue Sky multiples offer different perspectives than the above information. These auto dealer focused investment banks publish indications of dealership intangible value they encounter in the transaction space. For valuation purposes, these multiples can be used in conjunction with peer performance to explain the Blue Sky value of a dealership. If a certain branded dealership typically gets a 5-6x Blue Sky multiple, and the dealership is performing better than their peers, all else equal, they may get a multiple at the upper end or even above this range.However, not everything is all equal. You’d pay more for a dealership that delivers consistently strong returns. But how much of the increased value is due to higher earnings and how much is to a higher multiple?If a company is underperforming its peers, but the buyer believes they can improve performance up to peers, a higher value paid on lower historical earnings implies a higher multiple, so even an underperforming dealer might get a higher multiple than a better performing peer.Multiples are based on some indication of value and some indication of earnings; they frequently describe value rather than prescribe value. Stated more simply, a valuation does not simply derive tangible book value and apply the mid-point of the Blue Sky multiple range to pre-tax earnings. A proper valuation will determine the value of the dealership and be able to communicate why the implied Blue Sky value is reasonable within the context of historical and expected earnings and compare this performance to that of its relevant peers.ConclusionIn total, these various sources offer plenty of perspective into the historical performance and expected value in the marketplace for an auto dealership. Each source offers a different type of insight, and each comes with its own strengths and drawbacks. We have summarized data available from RMA and NADA in the following table.For a better understanding of where your dealership stacks up relative to peers and potentially in the marketplace, contact a member of the Mercer Capital Auto Dealer Valuation team today.

How Each Presidential Candidate’s Policies Would Impact the Auto Industry

Tale of the Tape

With the election just two weeks away, we think it’s timely to discuss the candidates’ platforms and determine the impact of their differing policies. Each candidate’s platform contains positions on many issues – some that would directly impact the automotive industry, and others that would indirectly impact the industry. A vote for one doesn’t necessarily signal a vote for the automotive industry or vice versa. While we don’t intend for this blog post to be political, we will examine each candidate’s position on four issues and discuss their impact on the automotive industry: trade policy, taxes, energy, and the environment.Trade PolicyUnder the current administration, President Trump has eliminated the Trans-Pacific Partnership and re-negotiated the North American Free Trade Agreement (NAFTA) by creating the United States-Canada-Mexico Agreement (USMCA). In addition to these agreements, Trump has created Section 301 Tariffs designed to impose taxes on vehicles that are assembled and imported from China. The latter aimed to promote more manufacturing in the United States and create new automotive plants in some key states, such as Michigan and Wisconsin. The moves have certainly forced several automakers such as Volvo, Ford, and Cadillac to shift some production for some of its models out of China to other countries in Europe to avoid the tariffs, but the direct impact these regulations have had on the creation of new manufacturing plants in the United States is unclear. Michigan, for example, has seen an increase in foreign investment in assembly plants, but not a large increase in new manufacturing plants over the last four years.Former Vice President Biden’s stated plans don’t differ too much with the USMCA. Since the cycle of a model of new vehicle manufacturing lasts upwards of seven to ten years, the potential threat of tariffs and taxes are somewhat offset by the sheer investment commitment. Biden’s messaging seems to aim at the possibility of more parts manufacturing and the creation of new auto parts plants in the United States. This initiative would assist in the promise to create new jobs domestically by a Biden administration.TaxesBiden’s tax policies appear to be aimed at raising corporate income taxes to approximately 28%. Additionally, Biden would propose a 10% “offspring penalty” surtax on profits made by American companies on goods produced abroad but sold in the United States. The latter policy is sought to discourage American companies from shifting assembly and manufacturing abroad to avoid corporate taxes in the United States.One of Trump’s early accomplishments in his first year in office was to lower the corporate income tax rate to 21%. Until the recent effects of the global pandemic, the lowered tax rates were a big contributor to the success and growth of the U.S. economy. Trump has boasted about further tax reductions in a second term, but specific information has not been provided. Under the Trump administration, the tariffs discussed previously have led to an overall increase in prices of imported automobiles since 2016.Energy and Electric Vehicles (EVs)The Trump administration has methodically rolled back emissions standards and mandates imposed under the prior Obama administration through the Corporate Average Fuel Economy (CAFE). Trump has also eliminated rules whereby California could set and impose tougher emissions standards than those instituted by the Environmental Protection Agency (EPA). The rollback of CAFE standards could reduce the demand for electric vehicles and sustainable batteries. Trump has also phased out, or allowed to expire, $7,500 EV tax credits for several manufacturers during his first term.Biden is committed to cleaner energy and has adopted a “Cleaner Cars for America” Proposal. Biden would potentially discard the rollback items from the Trump administration and provide further government assistance to manufacturers of EVs by promising the government will shift 3 million fleet vehicles from gas-powered to electric-powered. Additionally, Biden’s plan would develop 500,000 new electric charging stations designed to promote consumer confidence in EVs. It is also believed Biden supports additional tax mandates to support EVs, perhaps re-enacting the EV tax credits among others.EnvironmentUnder his plan for cleaner energy, Biden would continue to push for further cuts in air and water pollution in addition to the energy and emissions impact discussed earlier. Biden’s energy and environment policies could eventually lead to a similar “cash for clunkers” program designed to promote electric and hydrogen-powered vehicles. It is also rumored that Biden will seekeven higher fuel economy standards than those under President Obama. Specifically, Biden plans to tackle a worldwide ban on fossil fuel subsidies and a net-zero emissions policy no later than 2050.Trump’s policies regarding the environment and government regulations are not anticipated to change much from his previous term, as he most likely will continue to favor deregulation of environmental programs and his rollbacks of CAFE, along with lower fuel prices, could lead to increased demand for SUVs and less demand for clean vehicles and EVs.ConclusionWe’ve highlighted just a few categories of each candidate’s proposed plans and how they impact the automotive industry. As with all industries, the automotive industry is affected by numerous macro and micro factors that evolve over a longer period. The true impact of each candidate’s policies and the policies that have already been enacted may not be truly known for years to come. A summary of those key differences in each candidate’s proposed policies are as follows:Consult a professional at Mercer Capital to find out the valuation of your auto dealership or how it can be impacted in the future. Mercer Capital has extensive experience providing valuations of auto dealerships for a variety of purposes.

Last Quarter Took an L, but This Quarter We Bounce Back

SAAR Is Reaching a Post-Pandemic High, and Pent-Up Demand Is Leading to an Expected Bounce Back of M&A Activity

In September, lightweight vehicles marked a notable accomplishment during a tumultuous year, increasing to a seasonally adjusted 16.3 million. This is a 10% pickup from August, and the fifth consecutive monthly increase as the industry is recovering from lows at the beginning of the year. Though this is the highest SAAR seen post-COVID, it was still 4% below September 2019. Raw sales volume in September was actually up 6.1% from this time the prior year at 1.34 million, but this increase can be attributed to calendar year differences (and two additional selling days) with Labor Day weekend sales being including in September this year rather than August. Still, these are encouraging signs after a year of uncertainty for the industry. Strong demand for light trucks continued in September and supported volume growth, as well as ASPs. JD Power noted that a shift toward more expensive trucks/SUVs is a key driver of this price growth, with trucks and SUVs on pace to account for 76% of retail sales vs. 72% a year ago. The ASP is expected to rise 5.6% to $35,655. Despite overall price increases, the Fed has indicated interest rates will remain near zero for an indefinite period of time, which will aid in vehicle financing and help mitigate some of these transaction price hikes for consumers. Higher trade-in values are helping to offset some of the price increases as well, as used vehicle sales have been doing well with consumers seeking budget friendly options as economic struggles continue. Inventory constraints continue to plague the industry, although there has been some recovery. Inventory on dealers’ lots totaled 2.66 million units, an increase of 3.6% from August 2020 but down 26.7% compared to September 2019. Potential headwinds for the rest of the year include unemployment and the stalled government response to providing pandemic relief to consumers. Though job rates have been continuing to improve, the rate of recovery has slowed, and weekly jobless claims remain above pre-pandemic levels. Earlier this year, personal income levels were actually higher than pre-pandemic months due to increased unemployment benefits. Now that these benefits have elapsed, personal income levels are declining, but the unemployment rate remains elevated. As of September 2020, the unemployment rate was 7.4% compared to 3.5% the same time last year. More people out of work (without long-term job stability regardless of enhanced unemployment benefits) means less disposable income that can be directed toward large purchases such as vehicles. Slowed government response is also troubling for the industry as capital injection into the economy would help consumers increase spending levels. However, with Congress still at odds on a relief bill, and the current administration calling for halted negotiations due to differences in the appropriate stimulus amounts with House Democrats, the timing of further government assistance to reach consumers is uncertain. M&A ClimateAs we mentioned in our blue sky multiples post last week, M&A activity for dealerships in the first half of the year has been delayed or cancelled as uncertainty has widened the bid-ask spread. However, there is evidence of pent-up demand with Haig indicating that of the 42 dealerships that transacted in Q2, 33 were sold in June. As buyers and sellers start coming back to the market, there are expectations of the second half of the year to reach record levels as buyers continue to have strong convictions on the industry’s earnings growth and are impressed by the resiliency of the auto retail’s business model. And with interest rates poised to remain low indefinitely, buyers seek to capitalize on the low cost of capital. As Erin Kerrigan, managing director of Kerrigan Advisors noted,I see buyers really looking at this period as a moment in time to truly transform their business and make significant acquisitions to capitalize on the benefits of economies of scale.Public dealerships in particular are interested in the benefits of economies of scale as they try to further their prevalence in the market. Though there has been a bit of stagnation on the deal side during the beginning of the year, as we mentioned in our Q1 earnings call, executives believe consolidation in the industry will ultimately resume, and companies focused on maximizing liquidity may be best positioned to partake.Some of these public dealerships haven’t been holding off, however, with Asbury and more notably Lithia, resuming their acquisition efforts in Q2. As we discussed previously, Asbury acquired 12 franchise locations in Texas in July after the deal had initially been stalled at the beginning of the year. This acquisition has brought Asbury’s franchise mix to approximately 50/50 luxury and non-luxury.Lithia has been particularly acquisitive, as they have agreed to purchase various dealerships which are expected to generate an additional $2 billion in annual revenue. This is tacked onto their previous purchases this year that are expected to generate $1.7 billion in annual revenue (highlighted by the 10 Texas stores from John Eagle Dealerships that are anticipated to contribute $1.1 billion in revenue). In total, Lithia is expected to add $3.7 billion in additional revenue through store acquisition for 2020. This is part of Lithia CEO’s Bryan DeBoer goal set in July of the retailer reaching $50 billion in annual revenue by 2025 (almost four times their 2019 revenue). As he told Automotive News,The opportunity for consolidation within our industry remain plentiful, and our pipeline for acquisitions remains full.In total, Lithia has purchased 16 stores this year for a total now of 200 dealerships nationally. The Q3 earnings call that will be coming up should shed more light on the overall dealership sentiment toward acquisitions for the rest of the year. Be sure to stay tuned for our Q3 earnings call blog where we will break down the overall themes for the industry.M&A is going to be particularly important going forward as dealerships try to scale and consolidate fixed costs. Inventory constraints are leading to high gross margins per vehicle for the time being, but once inventory returns, margins will most likely decline once again. Volumes sold will return as an important consideration for dealerships. Furthermore, scale can be beneficial for dealerships in terms of expanding their technological capabilities and reach consumers digitally.Implications for Your DealershipWith SAAR and the buy/sell market bouncing back, the situation for many auto dealers seems to have improved significantly since the spring. Overall better sales and higher blue sky multiples are contributing to many dealerships increasing in value, and with the second half of 2020 predicted to have an active market of both buyers and sellers, now may be a good time if you are looking to sell or buy.If you are interested in how these current trends may be affecting the value of your dealership specifically, feel free to reach out to us. Mercer Capital has worked extensively with dealerships for the purposes of corporate planning, gift tax and estate planning, buy-sell agreements, and litigation support.We hope that everyone is continuing to stay safe and healthy during this time!

Take Advantage of Current Estate Planning Opportunities While You Can

It’s nearly impossible to discuss anything automobile-related without mentioning the name Henry Ford. Henry Ford established the Ford Motor Company in 1903 and also became one of the founding fathers of the automated assembly line mode for the production of his Model T vehicle. One of the famous quotes attributed to Mr. Ford is that “failure is only the opportunity to begin again.” This adage continues to inspire the auto industry today as it attempts to recover from turbulent economic conditions caused by the COVID-19 pandemic, much like its recovery from the Great Recession just a decade ago.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012.While economic recovery is still uncertain as the pandemic continues on and new relief bills are on the ropes, there currently exist potentially attractive estate planning opportunities for auto dealer owners.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012: 1) potentially depressed valuation of assets and businesses; 2) historically low interest rates; and, 3) uncertainty regarding the political administration going forward. Let's delve a little deeper into these three factors.Potentially Depressed ValuationsAt its core, the valuation of a business consists of three assumptions: cash flow, risk and growth. Cash flow can be defined as the expected earnings of a business into the future. With no certainty of the future, historical performance and recent performance can serve as a starting point for those future expectations. The second assumption is risk: what are the risks that the company faces to achieve those expected cash flows? Risks can be internal such as labor and management or risks can be external such as the economy or competition. The final assumption to valuation is growth: how are cash flows expected to grow in the future?All three of these valuation assumptions have been threatened by the pandemic. Recent cash flow has been threatened for most industries, not just the hospitality, retail, and restaurant industries. Certainly, for businesses, operating and economic risks have increased during the pandemic. As far as growth and recovery, we’ve all gotten an education into the alphabet soup of recovery: can the recovery for the general economy be described as v-shaped, u-shaped, w-shaped, k-shaped, or some other letter?Historically Low Interest RatesThose familiar with the concepts of finance and valuation also understand the relationship between interest rates and value. Generally, as interest rates (and risk) increase, the value of the asset decreases and vice versa. The pandemic and summer/fall of 2020 has created a unique opportunity regarding interest rates, as the Fed has brought rates to near zero in order to combat the pandemic.How are interest rates used in estate planning? Attorneys utilize many structures when seeking to transfer family wealth from one generation to the next: Grantor Retained Annuity Trusts (GRATs), Charitable Remainder Unified Trusts (CRUTs), installment sales, interfamily loans, and many other structures. Most of these structures utilize some form of a note/loan between family members. Under current tax law, a family member could not make an interest-free loan to a child or grandchild without that portion of the loan being considered as a taxable gift. To shield that portion of the loan from being a taxable gift, the loan must carry a stated interest rate. The IRS establishes guidelines for these interest rates in the form of Applicable Federal Rates (AFRs), which are determined monthly by the U.S. Treasury. The mid-term AFR rates have been historically low, and below 1% for most of 2020.The mid-term AFR rates have been historically low, and below 1% for most of 2020.How do low AFRs assist in estate planning? In addition to satisfying the IRS’ requirement so that the interest portion of the loan will not be treated as a gift, the lower level of AFRs should motivate estate planning this fall. Often, the structures that attorneys use in this form of planning (discussed above) depend on the cash flow from the asset being transferred (perhaps an operational business as an example) to fund the debt service in connection with the loan. In times of lower AFRs, the debt service is reduced, and it’s easier for the cash flow from the asset to cover the debt service. Additionally, the success of these transfer vehicles is usually dependent on the potential growth and appreciation in value of that asset after it is transferred to the next generation. With historically low AFRs and greater expected rates of return on the transferred assets, there are potential arbitrage opportunities on the spread of those returns.Uncertain Political ClimateThe fall of 2020 brings with it the national election season, and along with it, potential political change. Two important tax provisions that affect estate planning are at stake: the estate tax credit and the step-up basis for tax treatment. The current estate tax credit is $11.6 million per individual, meaning a married couple can shield and pass an estate worth $23.2 million ($11.6 million times two) to their heirs without incurring estate taxes. This provision is set to sunset in 2026 and will return to an amount of $5 million-plus inflation adjustments, expected to settle at a figure between $6 - $7 million per individual. At those levels, the unified estate tax credit limit for couples would lower by approximately $9.2 million, resulting in a greater pool of family estates that would be subject to estate taxes. If a new party wins the White House this fall, this provision could be debated and potentially changed sooner than 2026.Two important tax provisions that affect estate planning are at stake.A second tax provision that aids in estate planning could also be in jeopardy this fall. Among the pillars of Vice President Joe Biden’s proposed tax plan is the elimination of the step-up basis for taxation. Under current U.S. tax laws, the assets of an estate pass to their heirs at a tax value established at death (or alternate date of valuation). The value is transferred to their heirs at this established value at death or a stepped-up basis. Biden’s proposed tax plan would eliminate this step-up basis. Consider an estate portfolio with a value of $10 million and a tax basis of $2 million. Under the current unified estate tax credit, the portfolio example would not be subject to estate taxes and would transfer to the heirs at a stepped-up basis of $10 million. If the step-up basis was eliminated, the portfolio would transfer to the heirs at a basis of $2 million and would also be taxed on the imbedded capital gains of $8 million. There are also discussions that a change in power in the White House could also lead to increases in the capital gains tax rates, which are currently set at 15-20%. Increased capital gains tax rates and the elimination of the step-up basis could greatly diminish the value of a family’s portfolio at the death of the patriarch/matriarch.Unique Estate Planning Opportunities in Auto Dealer Industry TodayAs discussed above, this fall brings a unique opportunity for owners in the auto dealership industry to capitalize on low interest rates for planning tools and potentially lower valuations of the underlying assets being transferred. Last week’s blog covered the market’s update on Blue Sky multiples. Despite market optimism, valuation and blue sky multiples of auto dealerships are still very specific to the individual dealership and consider their unique conditions including financial performance, competition, and local economic conditions among other factors.In a previous Family Business Director blog post, colleague Travis Harms also discussed the impact of real estate on estate planning. It’s very common for the operations of the dealership to be contained in one entity and the real estate where the dealership resides to be contained in a separate asset holding company. Often when owners of auto dealerships desire to transfer their wealth/assets to the next generation, they may have children that are active in the business and they may have children that are not active in the business. We have consulted with owners on a strategy to gift interests in the operating business to the active children and interests in the real estate holding company to the non-active children. Owners/parents often view this strategy as equitable to their children and seek to reward/incentivize the active children with a direct interest in the operations of the dealership.ConclusionNow is a unique time, rife with estate planning opportunities with potentially lower valuation of assets, historically low interest rates, and changing political winds. Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equally. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation. Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning. Mercer Capital has extensive experience providing valuations for estate planning and valuations specific to the auto dealership industry.

Blue Sky Multiples Rebound from Q1 Declines but Full Recoveries Reserved for Top Brands

Blue Skies Ahead?

Last quarter, we sat down (virtually) with Kevin Nill of Haig Partners to discuss M&A trends in the Auto Dealer Industry. He noted amidst the uncertainty, buyers and sellers were either applying pre-COVID multiples to lower earnings or lower Blue Sky multiples to pre-COVID earnings. Sluggish deal volume continued into Q2 with transactions down 16% compared to 1H 2019, but the pace is picking up.In this post, we review Haig Partners' Q2 report on trends in auto retail and their impact on dealership values. We also look at how Blue Sky multiples have rebounded after declines in Q1. While most brands saw a partial recovery, a return to pre-COVID multiples was largely reserved for brands with the highest multiples in their category (luxury, mid-line import, and domestic).The Haig report succinctly described the landscape thusly:When customers couldn’t come into showrooms, dealers responded by selling vehicles online. When inventory levels for new vehicles fell, dealers focused on used car sales and were able to hold for more gross on both new and used vehicles. While waiting for the recovery, dealers reduced advertising, personnel and floorplan expenses significantly. The pandemic forced dealers to adopt new technologies and leaner business practices sooner than they otherwise might have. The result is that most dealers have become stronger during this time of crisis, not weaker. Investors have noticed. The publicly traded franchised groups have higher values today than before COVID, and we have seen the values of private retailers rebound as well. Dealership buyers are betting that the future of auto retail is bright, even when the lift from trillions of dollars of government stimulus spending wears off.Activity Ground to a Halt, but It’s Picking Back UpAccording to Haig, about 25-30 dealerships have been bought/sold each month on average. While the pandemic curbed activity significantly from March through May, there is evidence of pent up demand. Haig indicated that of the 42 dealerships that transacted in Q2, 33 were sold in June.While transaction activity has largely come from private acquisitions as seen above, our review of public franchised auto dealer earnings calls indicates public acquisitions are likely to pick up. Public companies, such as Lithia and Asbury (with its Park Place acquisition) have increased their appetite for acquisition. In order to compete in a digital world, public franchised dealers are looking to scale their operations. Online-centric competitors such as Carvana and Vroom have experienced rapid growth in recent years, though they are used vehicle dealers and thus uninhibited by franchise agreements. In order to add scale, public franchised dealers will need to leverage their relationships with OEMs and be more pragmatic in their growth. Still, scale is anticipated to benefit these players by spreading digital innovation costs over higher revenues.Advantageous Buying Opportunities Were Somewhat Short-LivedAs we mentioned above, deal activity from March through May was paused for numerous reasons. First, having to perform the due diligence process virtually reduces the likelihood of a transaction between two parties that don’t know each other well, even if both sides were eager to press forward. Widening gaps in valuations between buyers and sellers also made sellers less likely to relinquish their assets in a spiraling economic climate at the onset of the virus. After all, for many families, their auto dealership is the principal asset on the family balance sheet, and owners were wise to hold tight to their assets in a spiraling economic climate.According to Haig, COVID caused buyers to pull offers or demand price concessions amid concerns of earnings stability. However, buyers have come back to the table in recent months as profits have been much stronger than initially anticipated. Haig estimated Blue Sky values declined about 10% from 2019 levels in Q1; this figure ended up being only about a 5% dip in Q2. Kerrigan Advisors, another preeminent investment bank in the auto dealer space, sees Blue Sky values actually up 3.3% in Q2 2020 compared to Q4 2019. We’ll discuss the rebound in valuations in depth below.While SAAR has declined, gross profits (on a per vehicle basis) have improved.We see an interesting parallel in the minds of buyers, both of vehicles and dealerships. While SAAR has declined, gross profits (on a per vehicle basis) have improved. Through July, average new vehicle gross was up 7.8% per vehicle retailed compared to 2019, while used vehicles improved 5.1%. Consumers hoped an economic disruption would create a unique buying opportunity, but a lack of new vehicle inventory and interest rate tailwinds allowed dealers to raise prices. People with the financial wherewithal to purchase a new vehicle amid skyrocketing unemployment early on in the pandemic likely got a good deal, but NADA estimates incentive spending per vehicle declined 17% from April to August.Similarly, dealership buyers that were able to successfully negotiate price concessions on transactions already in progress likely got a good deal with the surprising earnings performance. Through July, average dealer sales were down 13.6% compared to 2019, but pre-tax earnings declined only 4.6%. As noted in The Blue Sky Report for Second Quarter 2020, published by Kerrigan Advisors, average dealership profits rebounded from lows to highs in the span of two months.Deals that were scuttled, delayed, or that didn’t even get off the ground, ultimately, may have benefited the seller that chose not to sell at the April lows. And as one of our colleagues has told me during the sell-side transaction process, every day you don’t sell your business, you are effectively buying it back at its current value in the marketplace. Dealers who chose to “re-buy” their dealership in April will be glad they did.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. The lone exception was Mazda whose multiples actually improved over Q4 2019. This likely has less to do with pandemic mitigation as it does with other recent troubles. While Mazda’s franchise sales fell the least (7% decline) of all the major franchises compared to 1H 2019, this may say more about 2019 performance than it does about pandemic mitigation. Its range of Blue Sky multiples has improved in each of the last two quarters, but Mazda still remains slightly below its range of 3.0x – 3.75x from Q3 2019.In Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.Every other brand declined about a half turn of pre-tax profits in Q1 (e.g. Mercedes-Benz fell from 6.50x – 8.0x in Q4 to 6.0x – 7.50x in Q1). Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations rebounded in Q2. However, only Porsche, Toyota, Ford, and Kia rebounded fully to their Q4 multiple range. Hyundai actually saw a modest uptick on the high end to pull even with Kia at 3.0x – 3.75x compared to 3.0x – 3.50x in Q4 2019.Notably, Porsche, Toyota, and Ford have recently been the leaders of their peer group. No luxury brands besides Porsche saw a full rebound to the top end of the pre-pandemic range. After years of tracking at the exact same range, Toyota stuck its nose in front of Honda, whose range only regained half of its pandemic losses. Similarly, Ford's Blue Sky multiples have moved in lockstep with Chevrolet since Q2 2018. Pre-pandemic declines to Ford's dealer valuations allowed Chevy and FCA to pull in front in Q4 2019. Now, all three of these domestic dealers sit at a 3.0x – 4.0x Blue Sky range with Buick-GMC just slightly behind.ConclusionFortunately, while there is still uncertainty about when the economy will return to “normal,” the auto dealer industry appears to have adapted to the circumstances at hand. Valuations have rebounded as earnings have recovered, and the industry has largely avoided the doomsday scenarios prognosticated in March. Still, not many people would have predicted working from home would remain so prevalent heading into October. As Q3 wraps up, we hope dealers continue to navigate these waters as they continue to re-buy their dealership.Blue Sky multiples provide a useful way to understand the intangible value of a dealership, particularly in a transaction context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to get the ball rolling.

Used Cars are Stealing the Spotlight

Consumers Seek Budget Friendly Options as Economic Struggles Continue

Lightweight vehicle sales have continued to improve since April, albeit at a slower pace than in previous months. August’s SAAR came in at 15.2 million units, a 4% increase from July. This is notably a smaller increase than we have seen in previous months compared to the 11% increase in July and other double-digit increases across the previous months.August’s SAAR came in at 15.2 million units, a 4% increase from JulySAAR has yet to rebound to pre-COVID levels, down 11% from this time last year. However, it is worth noting that there were two fewer selling days last month than in August 2019, which also included the Labor Day sales weekend. September 2020 sales are likely to see a boost from the previous year with this calendar difference. However, even after making an adjustment to factor in the calendar discrepancy, retail sales volume in August was still off by 10% year over year. Overall for the year, total SAAR values are 80% of what they were in 2019.As NADA notes, there was higher vehicle turnover at dealer’s lots than this time last year with 45% of vehicles sold this August spending fewer than 20 days on the lot. This is up from 35% in August 2019. Vehicle incentives have continued to decline as well, down $49 from August 2019 and $848 from highs in April 2020.Overall Economic Struggles Continue to Plague the IndustryAlthough dealerships have shown an astute ability to pivot their business models to withstand this pandemic (check out our post on dealerships shifting to online sales for more on this), the overall stagnation in the economy from this dragging pandemic continues to be a hurdle for most industries. The government's stimulus package, which included the $1,200 payment to Americans and the extra $600-a-week payment to mitigate the effects of the pandemic, contributed to increased retail spending through June. However, with no second round of checks having been distributed and these packages expiring, spending has once again taken a hit.August retail sales were up 0.6%, below the 1% consensus estimate. July retail sales were also revised lower, to 0.9% from 1.2%. Sales at auto dealerships make up about 20% of total retail sales. Without Congress passing another stimulus bill, growth in sales could continue to decline. This could have stark implications for dealerships going forward, as lower spending affects big-ticket items such as automobiles more acutely than smaller necessities.Used Car Market Is Picking Up SpeedWith a shaky economy on many people’s minds, a winner in the auto dealer industry is emerging: the used car market. With new car advertisements flooding airwaves, used cars have often been overlooked in favor of “what’s new.” We are also at fault for this, with several of our recent blog posts being centered around electric vehicles and new vehicle inventory constraints. However, used cars are stealing the spotlight.The first signs of the used car boom came in May and June with the overall economic downturn, with J.D. Power calculating that auto dealers sold 2.1 million used vehicles in May and June, 9% more than they did in the same time in 2019. This trend continued into July with 2.2 million used vehicles stockpiled at U.S. dealerships that month, representing a 22% drop compared to July 2019.[caption id="attachment_33733" align="aligncenter" width="801"]Source: FRED[/caption] There are a few reasons for used cars having a moment in 2020, and most of these stem from the COVID-19 pandemic. Many people have lost job security but also need a car so they are buying used cars to save some extra cash. Consider that the average new car price has increased 2.9% since last year to $38,035 while used vehicle prices have increased 0.7% and are 44% less than new prices. However, used prices are anticipated to climb as demand increases. New vehicle inventory constraints are also continuing to plague new car dealers. Although manufacturing has ramped up, it is still failing to meet consumer demands, and many models have been slim or scarce. As Thomas King, president of the data and analytics division at J.D. Power noted: Given the ongoing disruption that COVID-19 has on the industry, the fact that retail sales of new vehicles are only 4% below the pre-virus forecast is evidence of strong consumer demand for vehicles. The modest decline also is a result of significant inventory constraints. These constraints are directly curtailing sales where vehicles are not simply available and are creating follow-on effects that are affecting overall volumes. Specifically, the constraints mean that manufacturers are reducing vehicle incentives while dealerships are reducing the discounts off MSRP that they have historically needed to offer.With new vehicle inventory being tight, consumers may be showing up to dealerships in search of a new car that’s unavailable, but salespeople can sometimes effectively pitch them on a different used vehicle instead.Another reason for the used car market’s success has to do with a topic we have also discussed previously in our blog: the decline in consumer sentiment for public transportation. With consumers trying to avoid being in close quarters are the pandemic drags on, Americans are buying used vehicles as backups to avoid trains, buses, and ride-sharing services.Finally, the used car industry has been at the forefront of using technology to reach their consumers remotely. As we discussed in our blog post on the Vroom IPO, Carvana and Vroom have been leading the way on bringing car buying into the 21st century and enabling consumers to purchase their product from anywhere. Although new car dealerships are picking up on the trend and adapting to circumstances, competing with many of these online used car dealers who have been developing their infrastructure for years is a tall order.The used car industry’s time in the spotlight is limitedWith all of this being said, the used car industry's time in the spotlight is limited: automakers will catch up on inventory shortages, dealerships will have the cars that consumers want, and sale incentives will return as well. But how long will it take? As the economy continues to struggle and the pandemic continues, there is not much of a clear answer and most are having to take the “wait and see” approach. However, some dealership owners are bullish on the used car prospects.EchoPark, Sonic Automotive Inc.’s standalone used vehicle store, recently turned a profit for the first quarter ever, mirroring the used car dealership success we have been discussing. Looking forward, they have high expectations for the brand. As CEO David Smith notes,As we expand our footprint into other areas across the country, we believe EchoPark will exceed the overall volumes and profitability of our franchised dealerships[…] We believe the combination of our customer-centric shopping experience, high-quality vehicle offerings, rock-bottom pricing and transparent trade-in appraisals is disrupting the pre-owned markets that we serve.If EchoPark has the success that Sonic Automotive is predicting, we could potentially see more public dealerships trying to capitalize on the used car boom moving forward as well.Looking ForwardLooking into September, there most likely will not be many significant changes regarding SAAR. As mentioned earlier in this post, year-over-year September may see a boost from the way the calendar year falls, but once adjusted for this, it is unlikely that we will see any significant trend changes to what we have been observing over the past months.A potential event that could spur car sales, however, is if Congress can come to an agreement on a stimulus package deal. While it is most likely not arriving in September, both parties are eager to pass a bill and get money into American's hands before Congress breaks prior to the election. In doing so, we may see the kind of growth rates in SAAR that we discussed in April or May as the economy gets a boost. Ultimately, however, it will be difficult for the auto dealer industry to reach pre-COVID sales until this recession ends, which will likely coincide with a vaccine. Positive vaccine results are a glimmer of hope for a return to normalcy in the future, but for now, a strong stimulus package that gives Americans more spending money is probably the best near-term scenario in driving auto sales growth.If you are interested in learning more about what this means for your dealership, feel free to reach out to us. We hope everyone is continuing to stay healthy and safe during this time!

Does Personal Goodwill Apply to Auto Dealerships?

Observations from Recent Litigation Engagements

The concept of personal goodwill was a common topic in several recent auto dealer litigation cases. Not only is the presence (or not) of personal goodwill in a business, no matter the industry, hotly debated, but so is the quantification of that personal goodwill. However, I think the most important question to ask is “does it exist?” Often with ambiguous concepts like personal goodwill, the adage “you know it when you see it” is the most appropriate answer.What Is Personal Goodwill?Personal goodwill is value stemming from an individual’s personal service to a business and is an asset that tends to be owned by the individual, not the business itself. Personal goodwill is part of the larger bucket of an intangible asset known as goodwill. The other portion of goodwill, referred to as enterprise or business goodwill, relates to the intangible asset involved and owned by the business itself.[1]Commercial and family law litigation cases aren’t typically governed by case law resulting from Tax Court matters and can differ by jurisdiction, but Tax Court decisions offer more insight into defining the conditions and questions that should be asked in an evaluation of personal goodwill. One seminal Tax Court case on Personal Goodwill is Martin Ice Cream vs. Commissioner.[2] Among the Court’s discussions and questions to review were the following:Do personal relationships exist between customers/suppliers and the owner of a business?Do these relationships persist in the absence of formal contractual relationships?Does an owner’s personal reputation and/or perception in the industry provide intangible benefit to the business?Are practices of the owner innovative or distinguishable in his or her industry, such as the owner having added value to the particular industry? Another angle with which to evaluate the presence of personal goodwill, specifically to professional practices, is provided in Lopez v. Lopez.[3] Lopez suggests several factors that should be considered in the valuation of professional (personal) goodwill as:The age and health of the individual;The individual’s demonstrated earning power;The individual’s reputation in the community for judgment, skill, and knowledge;The individual’s comparative professional successThe nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.Why Is Personal Goodwill Important?Many states identify and distinguish between personal goodwill and enterprise goodwill. Further, numerous states do NOT consider personal goodwill of a business to be a marital asset for family law cases. For example, a business could have a value of $1 million, but a certain portion of the value is attributable and allocated to personal goodwill. In this example, the value of the business would be reduced for personal goodwill for family law cases and the marital value of the business would be considered at something less than the $1 million value.How Applicable/Prevalent Is Personal Goodwill in the Auto Dealer Industry?Readers of this space know that in any writing pertaining to litigation matters, we always try to avoid the absolutes: always and never. The concept of personal goodwill is easier identified and more prevalent in service industries such as law practices, accounting firms, and smaller physician practices. Does that mean it doesn’t apply to more traditional retail and manufacturing industries? In each case, I think the fundamental question that should be first answered is “Is this an industry or company where personal goodwill could be present?”For the auto dealer industry, the principal product, outside of the service department, is a tangible product – new and used vehicles. In order for personal goodwill to be present in this industry, the owner/dealer principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business.Name of Owner/Dealer in the Name of the BusinessWe are all familiar with regional dealerships possessing the name of the owner/dealer principal in the name of the business. However, just having the owner's name as part of the business name does not signify the presence of personal goodwill. An examination of the customer base would be needed to justify personal goodwill.It would be more difficult to argue that customers are purchasing vehicles from a particular dealership only for the name on the door, rather than the more obvious factors of brands offered, availability of inventory, convenience, etc. An extreme example might be having a recognized celebrity as the name/face of the dealership, but even then, it would be debated how that materially affects sales and success."... just having the owner's name as part of the business name does not signify the presence of personal goodwill."Auto dealers attempt to track performance and customer satisfaction through surveys, which could provide an avenue to determine this value (if for example factors that influenced the decision to buy listed Joe Dealer as being their primary motivation) though this is still unlikely and would be subject to debate.Another consideration of the impact of a dealer’s name on the success/value of the business would be how actively involved is the owner/dealer principal and how directly have they been involved with the customer in the selling process. Simply put, there should be higher bars to clear than just having the name in the dealership for personal goodwill to be present.In more obvious examples of personal goodwill in professional practices, the customer usually interacts directly with the owner/professional such as with the attorney or doctor in our previous examples. How often does the customer of an auto dealership come into contact or deal directly with the owner/dealer principal, or do they generally engage with the Salespeople, Service Manager, or General Manager?Presence of an Employment AgreementAnother factor that often helps identify the existence of personal goodwill is the presence of an employment agreement and/or non-compete agreement.The prevailing thought is that an owner of a business without these items would theoretically be able to exit the business and open a similar business and compete directly with the prior business. Neither of these items typically exist with an owner of an auto dealership. However, owners of auto dealerships must be approved as dealer principals by the manufacturer."Another factor that helps identify the existence of personal goodwill is an employment agreement and/or non-compete agreement."The transferability of a dealer principal relationship is not guaranteed, and certainly, an existing dealer principal would not be able to obtain an additional franchise to directly compete with an existing franchise location of the same manufacturer for obvious Area of Responsibility (AOR) constraints.So, does the fact that most dealer principals don’t have an employment or non-compete agreement signify that personal goodwill must be present? Not necessarily. Again it relates back to the central questions of whether an owner/dealer principal is directly involved in the business, has a unique set of skills that contributed to a heightened success of the business, and does that owner/dealer principal have a direct impact on attracting customers to their particular dealership that could not be replicated by another individual.ConclusionsPersonal goodwill in an auto dealership can become a contested item in a litigation case because it can reduce the value consideration. As much as the allocation, quantification, and methodology used to determine the amount of personal goodwill will come into question, several central questions should be examined and answered before simply jumping to the conclusion that personal goodwill exists.The difference in valuation conclusions between experts in litigation matters generally falls within the examination and support of the assumptions that lead to differences in conclusions. If present, personal goodwill for an auto dealership must exist beyond just having the owner’s name in the title of the business or the existence of an employment agreement.The existence and determination of personal goodwill can be a complicated topic. For more information or to discuss an issue in confidence, please don't hesitate to contact me.[1] In the Auto Dealer industry, goodwill and other intangible assets are referred to as Blue Sky value.[2]Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).[3] In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).

Is the Hype Sustainable?

How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market

As we mentioned in a previous blog post, the electric vehicle (EV) market has been all the rage lately, driven primarily by Tesla’s success in creating main stream electric vehicles. We’ve discussed the “Tesla Story” extensively in previous posts, and their stock has continued to rise. It was sitting around $2,200 last Friday (August 28), up from $216 last year, or an astounding 918%. Tesla split its stock 5-1 Monday and was hovering around $450 at the time of writing this post.As expected, other companies want to capitalize on the hype that Tesla has created in the industry, with EV start-ups trying to capture a slice of the pie. This summer has been a huge one for the industry, with electric vehicle startups Nikola, Fisker, Hyiilon, Lordstown, and Canoo all either going public or announcing plans to go public. Notably, however, they are not relying on the typical, lengthy IPO route to achieve this. Instead, they are using special purpose acquisition companies (or SPACs) to hit public markets quicker. In this post, we will walk through the companies going public, the deals, pros and cons of the SPAC, and what this could mean for your dealership.The EV Start-up ContendersNikola was the first of these EV start-ups to go public, announcing an IPO merger with VectoIQ Acquisition, a special purpose acquisition company, on March 3rd. After the merger was completed, the combined company was estimated to be worth $3.3 billion. Nikola was founded in 2015 and now is the global leader in zero-emission heavy duty trucks and hydrogen infrastructure. They hope to use the money raised from the public offering on the development of their electric semi trucks, of which they had around 14,000 preorders. This represents about $10 billion of potential revenue and three years of production. While the stock peaked 5 days after the offering at $79.73, the hype hasn’t lasted as its stock price has steadily declined back down to about $42 as of Monday. Despite the recent lackluster performance, future success is most likely hinging on if Nikola can deliver when they start rolling out vehicles.Hyiilon is seeking to follow in Nikola’s footsteps; on June 19th the company announced it would merge with Tortoise Acquisition, also a SPAC. At the time of the announcement, Nikola stock was up 80% from its IPO price, an encouraging sign for Hyiilon, who differentiates itself from Nikola and Tesla by offering a hybrid solution that works with existing diesel trucks. The company plans to introduce the first carbon-negative solution that will recycle natural gas. This, paired with a lighter design, could result in greater payloads that will lead to more profitable truck routes without having to invest in a totally new fleet. According to internal metrics, the company also outperforms Tesla and Nikola in range and payload capacity. The deal is expected to close in Q3 and once this happens, the ticker symbol will change from SHLL to HYLN, and Hyiilon will officially be a publicly traded company. Hyiilon has indicated that it will use the funds from the public offering for commercialization, production, and operations growth.While the Nikola and Hyiilon deals are in the heavy-duty truck space, Fisker, Lordstown Motors, and Canoo are EV start-ups in the standard light weight vehicle market. They announced their plans to go public through SPACs on July 13th, August 3rd, and August 18th, respectively. Fisker and Canoo both deal with traditional vehicles, though the designs are completely different. The founder of Fisker is best known for designing luxury vehicles for companies such as Ford, BMW, and Aston Martin. Looking to bring the same style to the electric vehicle market, Fisker and Spartan Energy Acquisition, a special purpose acquisition corporation backed by Apollo Global Management is expected to close in the fourth quarter, valuing the company at $2.9 billion. In a similar fashion, Canoo announced a merger with Hennessy Capital Acquisition Corp IV, another SPAC, valuing the company at $2.4 million. Canoo’s spin on the electric vehicle is a VW microbus-style van. Finally, Lordstown Motors entered the public space as well, trying to get more traction for their electric pickup truck, Endurance. Lordstown listed on its site some impressive features of the vehicle including 250-plus miles EV range, 7,500-pound towing capacity, and an 80 mph top speed. They are planning a merger with DiamondPeak that will give the company a pro forma equity value of $1.6 billion. Suffice it to say, there is a lot going on in the EV space right now.SPACsDespite some of these companies not even having a viable product yet, through the use of a SPAC rather than the traditional IPO route, these companies are all able to raise large funds from public market investors that are more averse to risk than private investors to back public development. Having mentioned the SPAC extensively above, it’s important to consider what it is specifically and why it could be considered so favorably by companies such as those in the EV industry. A special acquisition company (or SPAC) is a special type of company that goes public for the sole reason of buying another company regardless of how much it raises through an IPO. It’s for this reason that a SPAC is also known as a “blank-check” company. SPACs have become increasingly popular over the past few years, with 28 SPACs having IPO’d this year raising $8.9 billion. This is on track to reach $16.5 billion by the end of the year, a 21% increase from the prior year. What is prompting this SPAC boom? Some theorize that it has to do with the COVID-19 pandemic. IPO roadshows have become difficult to do in the current climate and don’t work as well remotely. Furthermore, there has been a shift toward one-on-one deals rather than one-to-many capital raises. However, while these circumstances can explain the increase in 2020, they fail to account for the increase over the past decade. Another favorable attribute includes risk mitigation for the selling company. The reasoning for this is because, with a SPAC, the company negotiates the price and then signs the deal. With a traditional IPO, it is the other way around, and there is no guarantee that it will be successful. Despite all of these factors, the most compelling argument for the SPAC boom doesn’t have to do anything with the cost (the SPAC is more expensive) or risk-mitigating factors, but instead primarily has to do with its timeline. With companies in “hyped-up” industries such as the EV market or the space tourism market (looking at you, Virgin Galactic), it makes sense for them to get to market as quickly as possible in order to extract gains in the market from this hype factor. Hence, the appeal of the SPAC. Despite all of the positives for companies, SPACs do have their drawbacks. One of these drawbacks is no reverse break fees, meaning that the potential to receive deal protection in the form of a reverse-breakup fee from the SPAC can be limited because of an inability to access the trust account cash other than post-business combination. Furthermore, since the SPAC structure is less risky for the company than an IPO, the SPAC should be compensated for this risk protection with an even bigger discount than regular IPO investors. Finally, there can be an uncertain amount of cash availability with SPACs due to a SPAC’s public stockholders having the option to elect to have their shares redeemed for cash in connection with the business combination. More investors redeeming their shares for cash means less cash for the company going public. How Long Can the Hype be Maintained?While in the 21st-century fads can catch on quickly and explode, they also have the potential to die out just as fast with “the next big thing” always around the corner. This seems to be the problem with companies that use SPACs to go public. Of the 222 SPAC IPOs since the start of 2015, 89 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -18.8% and a median return of -36.1% since 2015. This is a stark contrast to traditional IPO returns which have averaged 37.2% since 2015. Behind these numbers is a common trend of an initial pop when the company is announced followed by a further jump if it is priced right when it begins trading. However, declines tend to follow these initial bursts. Only 26 SPACs in the group have had positive returns as of the end of July. It seems that while SPACs could be useful for helping a company ride the interest-wave in order to raise funding, they have to have a product that isn’t just hype-worthy but can sustain consumer interest over the years.Key TakeawaysThough these public offerings may not initially impact dealerships directly, the surge of electric vehicle start-ups capitalizing on SPACs could mean there may be more electric vehicle alternatives to Tesla in the near future. Traditional manufacturers could ultimately try to acquire these start-ups in order to bolster their own electric vehicle offerings. For example, General Motors has invested $75 million in the Lordstown deal. If large traditional manufacturers pivot to larger EV offerings through the investment in these companies, dealerships could ultimately benefit from the larger selection being offered to consumers. Furthermore, as the use of SPACs to reach the public market increases in prominence, it is not out of the question that we see dealerships using this vehicle in the near future as well. With the main public dealers all reaching the market around the same time and there not being any new entrants in a while, the industry is overdue for some new players. While ultimately these thoughts are speculative, observing what is going on in the space can help companies prepare for what might be ahead.

Is the Hype Sustainable?

How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market

Q2 2020 Earnings Calls

Constrained Inventories and Improved SG&A Margins Expected to Normalize While the Future of Omnichannel Initiatives Stays Top of Mind

As expected, the COVID-19 pandemic has thrust many dealerships into relying on their digital and omnichannel offerings due to complications arising from stay-at-home orders. Further government restrictions have curbed new vehicle supply as manufacturers have struggled to ramp up supply. Many dealers noted inventory shortages. However, with sales volumes significantly below the 17 million seen over the last several years, both the numerator and denominator of the days of supply statistic are declining. Lower sales mean lower inventory isn’t a deal breaker; in the short term, limited supply has led to some gross margin improvement. However, total gross profit is still significantly down due to the lower sales (combination of lower inventory and lower demand). While sales have improved sequentially as restrictions have eased, parts and service (particularly collision) have trailed in their recovery as fewer miles driven has translated into reduced demand. Analysts inquired about the potential for stay-at-home orders to be ramped back up, particularly in large states such as Texas, California, and New York, though executives largely downplayed the likelihood and the impact it would have on their businesses.On Q1 calls, public auto dealer executives played down incremental costs related to digital initiatives and highlighted the reduction in SG&A related to online sales. Specifically, advertising and personnel costs are much lower for digital. In Q2, public auto dealers saw these initiatives come to fruition, and earnings largely beat estimates despite year-over-year revenue declines of 15-35%. Despite the successful cost cutting, executives were quick to point out not all of these cost savings were sustainable.Theme 1: Manufacturer plant closures have caused inventory shortages, but lower sales levels require less inventory. Some dealers noted higher gross margins due to their limited supply, while others highlighted issues sourcing their most popular models.Our second quarter new vehicle volumes declined 28%, and used vehicle volumes were down 14%, the latter of which was caused by inventory shortages. However, gross margin was extremely strong. New vehicle gross profit per unit was up 40% in the quarter. […] we are seeing a bit of an inventory strain in new and used and especially on the new side with some hot models that are typically our volume sellers. -Daryl Kennigham, President of U.S. and Brazilian Operations, Group 1 AutomotiveIt's going to be a tough road for July August September although we are seeing inventories improve. They're just not going to improve rapidly. I would look for October November time frame to get some normalized inventory levels. And the great news is this low supply equals high margin. -Jeff Dyke, President, Sonic AutomotiveWe are clearly constrained in inventory, and that means that for any given customer that comes to the site, the odds of them seeing the car they're looking for is lower, and therefore, your conversion rates will be lower. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaOur day supply was 52, down 34 days from the prior year. These levels are low, because of temporary OEM factory shutdowns. However, we expect the day supply to increase gradually through the summer selling season. -Dan Clara, SVP Operations, Asbury Automotive GroupTheme 2: Service & parts (primarily collision) fared better in April than vehicle sales. As the pandemic persisted, less mileage driven led to decreased demand due to less wear and tear.Collision is really what's taken the big hit for us […] when April really shut down for sales and service, collision was actually okay and then collusion took their hit in May forward. With less people driving on the road there's been less accidents. So collision has been a little bit further behind. -David Hult, CEO, Asbury Automotive GroupThere's just been people driving less mileage. And so our collision business, which isn't a massive part of our business overall. But it's probably the weakest when you look at it year-over-year. -Earl Hesterberg, President & CEO, Group 1 AutomotiveTheme 3: SG&A declined to lows as a percentage of growth for many of the public auto dealers. However, analysts and executives noted these results were unsustainable in the long-term.Store leaders continue to take prudent and decisive cost savings measures and personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions lead to significant sequential improvements throughout the quarter. Same store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. […] for the month of June, our company [SG&A] to gross profit improved to 57.4%, […] significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs. […] Our stores are well aware that their largest SG&A item is personnel. The next one is advertising. […] As we move forward, the target in SG&A gross percentage is 65% which we’ve talked about for years, I think it seems a lot more attainable in the near term. -Chris Holzshu, EVP & COO, Lithia MotorsWe were 64% which I would never [have] thought we'd be in the 60s with SG&A when looking at July 77% last year. […] We see less salespeople necessary to drive the business. The same thing on the fixed side. We're seeing better utilization of our people. […] I think advertising is moving from traditional to obviously online which obviously is less costly. -Roger Penske, Chairman & CEO, Penske Automotive GroupWe drove significant SG&A leverage through extensive cost reduction efforts, including leveraging our digital capabilities to reduce expenses across labor, advertising and discretionary spend. As Mike stated we will continue to maintain a discipline in our cost structure going forward, targeting to continue to operate SG&A as a percentage of gross profit below 69%. […] We were down about 40% in advertising year-over-year. Really driven by the environment and our digital capabilities and being far more efficient. -Joe Lower, CFO, AutoNationTheme 4: Digital innovation requirements loom large for smaller players who lack the scale to make the necessary investments. However, online used vehicle retailers do not have the same issues inherent to new vehicle retailing for traditional franchised players.Suddenly, buying cars online is becoming normalized. This is a big deal. We have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaI think there is a yearning in the pre-owned market for a brand that can be trusted. And scale also brings in the consumers' mind an idea of trust. And if you really have a good experience and you stand behind the product I think that's where the business is going to consolidate around and whether that's Carvana, CarMax, AutoNation, Vroom, I think the big players that are branded are clearly going to take share. It's a share consolidation in a very big ocean. That's how I see it developing. -Mike Jackson, Chairman & CEO, AutoNationIt's getting tougher and tougher for smaller independent dealers to be competitive in a world where the omnichannel and scale really matters so much. -John Rickel, SVP & CFO, Group 1 AutomotiveI know there's a lot of vibe in the market about growth and how big people can get over the years in consolidation in national branding. We have to remember that this is a franchise business. And that there's dealer agreement with every single one of these brands and then there's framework agreements on that. So until those documents materially change, I don't see the massive consolidation […] Once you start having multiple rooftops of any brand beyond your dealer agreement that exists, you have a framework agreement. And within those framework agreements there are limitations and how many you can acquire in an annual season […] And for a company A to buy company B of 40-plus stores overnight would take a significant amount of work with the manufacturers to make that happen and it would be a true test of some documentations that are out there. […] We all have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -David Hult, CEO, Asbury Automotive GroupConclusionDespite public auto dealership's excitement surrounding the addition of online sales and lower SG&A expenses, key questions still remain. First, are the true costs being measured? “Omnichannel” requires both an online and in person presence. Quoting GPUs or SGA as % of gross may become muddled when trying to apportion which line item expenses are stuck in. What’s important to remember is these costs still exist, even if they seem small relative to the potential sales pickup. Digital may be more cost effective, but a full-on shift into digital for auto dealers likely sheds less cost than expected. Unless dealers plan to significantly shift their real estate strategy, it appears there are limits to how much cost can be taken out of overhead, even if advertising and personnel can be more efficient.How long dealerships can keep advertising and personnel costs low also remains to be seen. In a period of high unemployment, people may be happy to have their jobs. If we forecast out a few years, will people remain as jubilant to continue to do the work previously assigned to more people? Technology should help reduce personnel costs, but we’re simply pointing out there are limits. And on advertising, digital is the cheaper option – for now. Digital advertising is less established but gives more insight into the successful conversion of customers. For example, how are you supposed to know if someone decided to buy because they saw your billboard? In the long-term, this could lead to higher pricing power for digital advertising platforms.Finally, while large auto dealers have the scale to invest in digital platforms, smaller dealerships do not have such luxury. Their digital platforms may be limited to only when consumers looking to buy a specific make or model Google the closest location and head to the dealership or their website for an omnichannel experience. While these platforms may pale in comparison to larger players, it works for now. The question may become whether smaller players are forced to make commensurate digital investments. In the bear case, dealers would look to exit when deal multiples recover. For those with a more bullish view, we tend to agree with comments made by Asbury’s CEO (worth noting Asbury has the fewest dealerships of the publics). Dealerships may not want to overburden themselves with overinvesting in digital initiatives that aren’t being pushed by their OEMs. While dealers can be prisoners of the moment or attempt to “Keep up with the Joneses”, to use two puns in one sentence, we also caution it could be a risky play for dealers that step out of their lane and look to materially shift their operations online to compete with the well capitalized players in the nascent space.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership. 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.

July 2020 SAAR

SAAR Increased to 14.5 Million in July, and Declines in Public Transportation and Ride-Sharing Usage Could be Creating Opportunities for Dealerships

SAAR has continued its upward trend coming in at 14.5 million, an encouraging 11% increase from June. However, sales continue to trail pre-COVID numbers with July 2020 14% below the same time last year.With demand picking up as customers can return to brick-and-mortar locations, dealerships aren’t feeling the need to offer as strong of incentives as they did at the start of the pandemic. According to JD Power, preliminary estimates put incentive spending for the month at $4,236 per unit, down from June 2020, but up by $166 compared to July 2019.As we mentioned in our previous SAAR post, inventory problems continue to be a difficult hurdle for dealerships to contend with as demand returns. JD Power reported that 41% of all vehicles sold in July spent fewer than 20 days on dealer’s lots, up from 35% a year ago.2020 is also proving to be an interesting year for new and used vehicles, as thin margins on cheap, new vehicles have manufacturers abandoning the investment. According to data from KBB, vehicles between $20K and $30K have declined from 44% of the market share in 2015 to 22% of the market share in 2020. Cars under $20,000 make up only 1.3% of new car sales so far this year. With the average price paid for a new vehicle around $39,000, this is way above many buyers’ budgets. As a result, entry-level buyers have been looking to the used car market instead. With the used car market getting bumps from new technologies, this has proven to be a viable and cost efficient option for new buyers.Pandemic Silver Linings for Auto DealershipsWhile the reopening of the country is bringing people back to dealerships, many places still aren’t being frequented like they had been in the past. Included in this list are bars, concert halls, and public transportation means. With fewer events going on, demand for ride shares has decreased significantly according to the Q2 earnings calls (stay tuned for next week’s blog post for a full rundown on those calls).The empty subways and buses should be on the radar of dealerships and could prove to be an ultimate silver lining among all of the negatives that the Covid-19 pandemic has created for auto sales. With social distancing difficult to achieve in a closed space environment like public transportation, there seems to have been a shift in consumer sentiment in favor of car ownership.The empty subways and buses should be on the radar of dealerships and could prove to be a ultimate silver lining to the struggles caused by the pandemic.A survey released in mid-July from CarGurus tracked customers’ views around buying a vehicle, and the results were striking! 39% of people planning to buy cars are looking to avoid ride-sharing, and 44% of them say they want to decrease or stop public transit use. Furthermore, as people start returning to the office, this number could increase, with 44% of people who take public transit to work citing that this is their top concern in returning to the office.As more data has been released noting the potential risks of using public transportation, the data surrounding people’s comfort level with public transport in the current climate is understandable. Even the government has become somewhat of a proponent of car ownership over public transportation during this time, as the CDC has encouraged companies to offer incentives for employees to use their own cars to ride to work, rather than public transportation or ride sharing.The Current State of Public Transportation and RidesharingWhen you look at the data behind public transportation usage since the pandemic began, it paints a clear picture of consumer preference during this time. Public transit ridership is measured by “unlinked passenger trips” with trips defined as whenever a person boards a transit vehicle, including transfers.Despite local governments pouring billions into public transit infrastructure, public transit ridership has been declining since at least 2014, with unlinked passenger trips falling 7.5%. The COVID-19 pandemic has escalated this decline significantly, with public transit unlinked trips dropping 85% from January to April at its lowest levels in more than a century. While this decline in usage could be attributed to overall declines in travel from stay at home orders, the graph below tells a different story. Vehicle miles did experience a decline as well, but it was strikingly smaller than that of public transit at 42%. Ridesharing services are facing a similar problem, as consumers are feeling uncomfortable sharing an enclosed space with a stranger. Uber has reported gross bookings on rides being down 75% in Q2. While Lyft declined to comment to the Washington Post on the impact of the pandemic on its business, the company has previously said its April ridership was down 75% in Q2. Recovery in this space as the country reopens has varied widely by city and state depending on which are reopening, recovering, or reimposing restrictions. For example, ridership recovery has been prominent in cities like New York that have recently been recovering after facing the brunt of Covid cases earlier this year. In San Francisco and Los Angeles, however, it has been depressed as California continues to struggle with its caseload. California’s gig worker legislation also poses an existential threat, particularly for Lyft where it derived 16% of its business. Manufacturers are encouraged by the changing sentiment surrounding car purchases, with Scott Keogh, Volkswagen’s U.S CEO noting that “We definitely do see a return to what I’ll call personal transportation and trust” and predicts a shift in consumer mindset to: “I know where this car has been; I know it’s mine.” What Increased Private Car Ownership Might Mean for the EnvironmentWith many cities having heavily invested in public transportation infrastructure, this Covid-induced fear of public transportation has many city officials nervous. New York City Mayor Bill de Blasio this past week issued statements against purchasing a car during the pandemic, as he told reporters “My advice to New Yorkers is do not buy a car. Cars are the past, the future is going to be mass transit – biking, walking – and there’s so many options right now and there’ll be more and more as we go forward.”The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions.While currently it may be safer to purchase a car to avoid unnecessary encounters with other individuals on public transit, ultimately this pandemic has an expiration date. More notable are worries that all of the efforts made to dissuade car usage for the sake of the environment could be unraveled through the emphasis on private car ownership.The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions if people turn to cars to avoid exposing themselves to the virus. University of British Columbia urban planning and public health professor Lawrence Frank notes that “promoting private vehicle use as a public health strategy is like prescribing sugar to reduce tooth decay.”However, both optimism from auto dealers on the prospect of new sales and concerns from public transportation advocates may be premature. With a vaccine predicted in 2021, consumer sentiments toward public transportation could easily revert back. Rebecca Lindland, an auto industry analyst, shares this viewpoint having seen previous trends come and go. For example, in 2008 when people started buying small fuel-efficient cars, she notes that “That only lasted two to three months, and then people went back to buying a vehicle that suited their wants and needs.” If people feel safer riding public transit with the development of COVID-19 vaccines and treatments, and parking and traffic once again become headaches, consumer preferences could shift off private car ownership.Looking ForwardWhile pandemic-related car sales stemming from public transportation avoidance may not be long-term, in the short run it could help boost dealership sales while they are trying to recover.However, many Americans are still hesitant to purchase a vehicle. This is despite a third of consumers saying they value having their own car more now than they did before Covid, and 93% were using cars more in the era of social distancing.The NADA expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle.This hesitation stems not from opinions on transportation, but rather on the state of the economy. As unemployment remains high and there are uncertainties surrounding future government stimulus, consumers could be waiting for a more stable environment to make large purchases such as vehicles.Nonetheless, the National Auto Dealer Association expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle. Inventory constraints may continue to plague the industry, but barring more production shutdowns, supply should ultimately be able to reach demand levels by end of the summer further supporting SAAR’s upward trajectory.

August SAAR

Whitepaper Release: Understand the Value of Your Auto Dealership

If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper

Electric-Vehicle Industry Is Heating Up

Policy and Oil Price Implications for EV Sales

I remember watching the movie Cars when it first came out in 2006. I was seven years old and can easily recall the infamous line Lightning McQueen would say before a race, “I am speed.” His determination on the racetrack was unrivaled as he went on to win many races and championships. However, Lightning’s winning tradition came to a halt in the third movie. He had lost his competitive edge as cars with new technology began to dominate the racetrack.Unlike Cars, however, the current focus for new auto technologies is less focused on speed, and more on sustainability, as there appears to be a shift in focus away from developing the century-old gasoline-powered vehicle to electric. The electric-vehicle (EV) industry has shown to be an attractive long-term alternative for manufacturers. In this post, we’ll survey the landscape including the beginnings of EVs, major players in the industry, and the future outlook.Origins of the Electric-Vehicle IndustryThe first electric-vehicle in the U.S. was introduced in 1890 with a top speed of 14 miles per hour. According to the American Census, by 1900, 28% of all cars produced in the U.S. were electric. However, Henry Ford’s mass production of gasoline-powered vehicles reduced the cost of this vehicle significantly. In 1912, a gas-powered car averaged $650 while an EV averaged $1,750, and as a result of this price disparity, EV’s lost a great degree of popularity.Fast forward nearly 100 years, and EV’s continue to trail their counterparts. For example, GM’s EV1 was produced in 1996 and contained 137 horsepower with a 0-60 mph acceleration time of about nine seconds. Moreover, charge time and range proved problematic with a 15-hour charge time and only a 90-mile maximum cruising range not drawing much consumer demand. As a result, this model was discontinued only after a couple of years of production. Charge time and range problems continued to plague the industry as manufacturers struggled to compete with traditional vehicles. However, in 2008, the EV industry revealed a glimpse of hope when Tesla Inc. released the all-electric Roadster. This vehicle had a range of almost 250 miles on a single battery with a 0-60 mph acceleration time of four seconds. These metrics were unrivaled in the EV industry, and Tesla ascended quickly as competitors could not compete with this level of technology in their batteries.Tesla’s Emergence as Market LeaderWhile Tesla dominates the industry, CEO Elon Musk revealed his intentions of offering a helping hand to its competitors. He recently tweeted the following: “Tesla is open to licensing software and supplying powertrains & batteries. We’re just trying to accelerate sustainable energy, not crush competitors!” Major automotive manufacturers have recognized Tesla’s dominance in the industry. Volkswagen (VW) CEO, Herbert Diess, reflects on Tesla’s technological achievements: “What worries me the most is the capabilities in the assistance systems. 500,000 Teslas function as a neural network that continuously collects data and provides the customer a new driving experience every 14 days with improved properties. No other automobile manufacturer can do that today.” Furthermore, Audi CEO, Markus Duesemann, recognizes the magnitude of Tesla’s accomplishments: “Currently, Tesla has larger batteries because their cars are built around the batteries. Tesla is two years ahead in terms of computing and software architecture, and in autonomous driving as well.” Tesla’s dominance in the EV industry is reciprocated by investor enthusiasm, though as we’ve noted, plenty of other factors are at play.Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales.As Tesla continues to expand its EV line and invest in new technologies such as autonomous vehicles, other automotive manufacturers have set their sights on expansion of their electric vehicle fleet to try and keep up. GM Chief Executive, Mary Barra is optimistic regarding the trajectory of GM’s influence in the EV industry. She states, “We believe in an all-electric future, and we’re moving aggressively to have vehicles that people want.” GM revealed plans to expand its EV fleet through 2023 with 20 new vehicles including a $20 billion investment towards electric and autonomous technologies. Similarly, Ford plans to invest over $11.5 billion through 2022 and plans to use aspects of its E-Mustang in future EV’s.While other companies are investing in this space, Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales. Other global models with a presence in U.S. markets that finished strong in sales for the year included the Nissan Leaf (#3), BMW 530e/LE (#6), Mitsubishi Outlander PHEV (#7), Hyundai Kona EV (#9), and the BMW i3 (#10). To put things in perspective, the combined sales of these other models still fell short of Tesla’s sales for its Model 3 alone.The Road to EV Success Paved by Government SubsidiesConsumers and manufacturers are increasingly showing interest in electric vehicles for their ability to reduce one’s carbon footprint. However, costs and infrastructure are proving to be difficult hurdles for them to catch up to petrol or diesel alternatives. The battery costs of an electric vehicle are showing to be the most acute, taking up 30% of the total costs of an EV. To help automakers past this hurdle, the government has provided subsidies to encourage electric vehicle sales. Each automaker is eligible for $7,500 in credits for each electric vehicle sold, up to $200,000 sales. Credit gets halved to $3,750 for six months after hitting that target, and then halved again to $1,875 for another six months. After that, the credit goes to zero. From 2014-2018, U.S. buyers claimed credits for 239,422 vehicles, worth $1.4 billion. So far, Tesla and GM have been the only manufacturers to hit the thresholds. Still, there have been proponents of the government extending incentives or increasing them to further support electric vehicle sales. With just over 2% of American vehicles sold last year being electric, losing federal tax credits could make the expansion of electric vehicles more troublesome.Costs and infrastructure are proving to be difficult hurdles to catch up to petrol or diesel alternatives.Beyond cost, electric vehicle manufacturers must improve poor supporting infrastructure. In March 2020, the U.S. had approximately 78,500 charging outlets and almost 25,000 stations for plug-in electric vehicles. While this number has been increasing over the years, it still pales in comparison to the approximately 115,000 gas stations in the U.S (which has sharply declined from much higher levels). Furthermore, a large portion of the total charging stations are in California.While daily commutes can be supported by overnight charging, consumers need to be confident that they can go on road trips and reliably find a charging station for EV’s to really take off. Electric vehicles have historically had an inferior range to their gas-powered counterparts. While the gap has narrowed over time, miles covered on one tank isn’t the only hurdle. Gassing up your car takes a fraction of the time required to fully recharge EVs, lengthening consumers’ ETA. California currently has 25% of charging stations and 35% of charging outlets. For EVs to become mainstream, access will have to be increased. So far, the government has been willing to subsidize purchases and incentivize production. There are also federal grants for cities and states looking to invest in the necessary charging infrastructure, but it will be interesting to see who foots most of the bill if EVs achieve the scale desired. More accessibility to charging stations should improve consumers’ interest in electric vehicles, though it won’t fully solve the problems of longer road trips.State and federal governments aren’t just using subsidies to power this shift, as there have been more regulations and requirements for more fuel-efficient vehicles. For example, the National Highway Traffic Safety Administration (NHTSA) and the Environmental Protection Agency (EPA) passed The Safer Affordable Fuel-Efficient Vehicles Rule (SAFE) which went into effect in March of this year. This rule tightens the fuel economy and carbon dioxide standards progressively by 1.5% each year from 2021 to 2026. Passenger cars and light trucks are subjected to this rule. This rule could undoubtedly act as a catalyst for manufacturers shifting additional focus towards EV production.Further, the Zero Emissions Vehicle (ZEV) program mandates a certain proportion of EV sales to non-electric sales in California and ten other states. Under this rule, plug-in hybrids, battery EV’s, and hydrogen fuel cell vehicles qualify as a ZEV. The 2020 ZEV production requirement is 9.5%, but it will rise to 22% by 2025.Tesla continues to capitalize on the benefits of producing strictly EV’s, as their 10-Q report indicated massive profits from the sales of regulatory credits totaling to $428 million in Q2 (about 7% of revenue). In order to dodge emission fines, other automotive manufacturers will purchase credits to make up for their own deficits in EV sales. For example, last year, Fiat Chrysler Automobiles (FCA) closed a deal with Tesla for about $1.3B in credits to stay in compliance with heightened European environmental regulations taking effect in 2021. Oil Price OutlookIn the past, high oil prices have increased the incentive to shift to electric. However, the pandemic’s disruption to global supply and demand of oil has significantly decreased the urgency in the near term. According to the U.S. Energy Information Administration (EIA), in March and April, consumption fell significantly for liquid fuels largely due to travel declines from stay-at-home orders. During this period, the consumption levels matched those of the early 1980s, hovering at an average of 14.7 mb/d (million barrels per day). As states reopened following the lockdown, liquid fuel consumption levels began to recover. However, amid coronavirus infections surging, another dip in liquid fuel consumption levels may be on the horizon. While low oil prices are the current reality, the ultimate resurgence of travel post-COVID-19 is expected to bring back higher oil prices. Volkswagen’s chief strategist, Michael Jost, does not view this year’s slump in oil prices as a barricade to the company’s transition for expanding its EV fleet. Jost does not see oil getting any cheaper in the long run, as he states, “We have a clear commitment to become C02 neutral by 2050, and there is no alternative to our electric-car strategy to achieve this.” While oil prices are expected to rebound, the International Energy Agency (IEA) projects a decline in North American oil demand through 2040, which is contingent upon the implementation of policy initiatives to curb greenhouse gas emissions. While the Stated Policies Scenario suggests only a fall in demand of 4 mb/d, the IEA projects a decline of 11 mb/d under the Sustainable Development Scenario, which the IEA views as a feasible solution for mitigating the potential impacts of air pollution and climate change. EVs through the Eyes of the ConsumerClearly, governments have both rewarded early adopters and outlined penalties for manufacturers that don’t increase compliance in the future. However, EVs still make up a relatively small size of the overall car market. Despite the aforementioned subsidies, the price mark-up of these vehicles to its gasoline counterparts continues to be a concern. For example, in June 2019, the average retail selling price of new cars was about $36,600 compared to $55,600 for EV’s. This is one of the big reasons why consumers are hesitant to purchase an EV. Subaru of America CEO, Tom Doll reflects on the public’s unwillingness to accept EV’s, as “people don’t seem to accept the (EV) price up. They sit at their kitchen table and consider their budget. They’re doing the price up for an EV and most say, ‘It’s just not worth it at this point, with gas prices being so low.” Still, Subaru is expected to roll out their first EV model in 2021.If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Rising fuel prices may renew interest in EVs, but upfront costs will likely be more important. Lithium-ion battery prices have decreased significantly since 2010, and it is believed that low battery prices will outweigh the benefits of low oil prices, thus propelling EV sales. Tesla’s move to develop a new cobalt-free battery could be a game-changer in decreasing over EV prices. The 30% reduction in wholesale battery prices expected in 2023/4 could mean a drop of 10% in car prices. As noted above, EV’s on average were about $19k pricier but had opposite trajectories. Where ASP’s increased about 2% annually, EV’s declined 13.5%. If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Concluding ThoughtsIt is safe to say that Lightning McQueen would be no match against Ford Motor Company’s new Mustang Mach-E 1400. It is expected to debut on the NASCAR track soon. As described by Mark Rushbrook, motorsports director of Ford Performance, the all-electric Mustang is “an all-around athlete” with an impressive 1400 horsepower.Technological innovation plays a vital role in the future of EV’s, as we have seen Tesla emerge as the industry leader through its technological advancements in software and battery capabilities. The future of the EV industry seems bright in the long-run as falling battery prices paired with heightened emission standards serve as pillars for sustaining the expansion of this sub-industry, even if consumers are less motivated to make the switch. However, manufacturers with significantly more scale than Tesla shouldn’t be too far behind and may ultimately eclipse them. The main concern for auto dealers lies in whether their manufacturer can develop models that are desirable to consumers and meet emissions regulations. Whether or not there is a meaningful shift towards EVs over the coming years, dealers will likely continue to adapt to consumer preferences as they always have.Our thanks to our summer analyst, Will Pesto, who drafted this post in collaboration with our Auto Dealer Group.

Fiat Chrysler & Peugeot (PSA) Merge into “Stellantis”

Analyzing the Timeline and Twists and Turns of a Transatlantic Merger During a Pandemic

Last week, we analyzed Asbury Automotive Group’s acquisition of Park Place, a deal scuttled by COVID-19 that came back to life under revised terms. This week, we are moving upstream to look at the merger between Fiat Chrysler (FCA) and Group PSA (manufacturer of Peugeot and Citroen) and observe the new name of the entity, the merits and hurdles of the ongoing deal, and some potential impacts on auto dealers.What’s in a Name?A fresh start with a new name feels reasonable.On July 15th, the name Stellantis was announced, which drew jokes from various people within the industry. The press release indicated the name comes from the Latin verb “stello," meaning to "brighten with stars.” The name will be used exclusively at the Group level, as a corporate brand, with the names and the logos of its constituent brands remaining unchanged. While the change drew some attention, we think it’s largely much ado about nothing. Sure, the press release was filled with a litany of corporate platitudes about how the name “draws inspiration from this new and ambitious alignment of storied automotive brands and strong company cultures …” but overall we think it might be more of a practical choice considering FCA-PSA doesn’t really roll off the tongue. Also considering its 18 brands on a combined basis, the sheer size of the transaction, and many previous corporate name changes, a fresh start with a new name feels reasonable.While Stellantis won’t appear on any of the cars, it’s not the only industry participant to not have one of its brands in the corporate name. GM and Daimler are the other exceptions in the industry whose names go back a lot longer. Every manufacturer besides Tesla makes cars under a brand other than the corporate name (Toyota makes Lexus, Volkswagen makes Audis, etc.).The company includes manufacturers in Detroit, Paris, Turin, Charlton, Russelsheim, and more. A full list of these brands are included in the graphic below.[caption id="attachment_32791" align="aligncenter" width="642"]*Parts manufacturer[/caption] Merits of the DealHaving exhausted the new name, let’s look at the deal. The deal was announced in October 2019, and in December, Group PSA and FCA released a joint press release highlighting:Benefits of scale in developing more sustainable, tech-savvy (including autonomous) modelsCombined company to be 4th largest global OEM by volume (8.7 million units in 2018) and 3rd largest by revenue (170 billion euros in 2018)Diversification across markets in Europe, North America, and Latin AmericaAnnual run-rate synergies of 3.7 billion euros with no plant closures50/50 merger expected to lead to investment-grade credit rating with high level of liquidity The company indicated 40% of its synergies would come from its combined technology, product, and platform. Stellantis expects another 40% of its synergies to come from sourcing its suppliers at a discounted price due to its bargaining power, or as the company called it, “enhanc[ing] its purchasing performance.” Savings on marketing, IT, G&A, and logistics round out the last 20% of anticipated savings. Mergers frequently try to cut duplicative costs and add to pricing power, both from suppliers and customers. However, since the combining legacy companies largely operate on different continents, minimal enhancements to market share are unlikely to drive higher selling prices to dealers and consumers. This could help enhance blue sky values for FCA dealers, which have lagged other brands. Enhancements to technology and tweaks to its platform could also help improve the brands’ SSI ratings, which were generally below their respective averages in 2019.Pandemic Impact on the Deal Regulatory HurdlesThe initial press release indicated the deal was expected to take 12-15 months subject to “customary closing conditions, […] and satisfaction of anti-trust and other regulatory requirements.” While the COVID-19 pandemic was certainly not anticipated, the reasons for the deal are “stronger than ever,” according to FCA Chairman John Elkann. Last month, PSA CEO Carlos Tavares also expressed confidence that the $50 billion merger will proceed as planned, noting “the merger with FCA is the best among the solutions to cope with the crisis and its uncertainties.”The deal structure of the Stellantis merger shields it from some inherent issues in acquisitions.While many auto dealers are seeing transactions being placed on pause, the deal structure of the Stellantis merger shields it from some inherent issues in acquisitions. During the pandemic, acquirors are looking to either use a reduced Blue Sky multiple on 2019 earnings or an old multiple on reduced 2020 earnings. This has widened the bid-ask spread, as dealers don’t want to sell at depressed values. With this stock swap merger of equals (“MoE”), each side has to provide equal value to the deal, and pandemic related concerns may cancel each other out. According to Elkann, “both parties in FCA-PSA deal are committed to get parity in the merger deal.” PSA shares are set to be exchanged at a rate of 1.742 shares of the new combined company for each share contributed by FCA. However, it is possible the pandemic has disproportionate impacts on the two companies, requiring a change in the exchange ratio based on adjustments to their relative contributions.There are other issues at play besides the exchange ratio before this deal can be finalized. Both sides have already announced they no longer intend to pay their planned ordinary dividends of 2.2 billion euros for 2019 results which was included in the initial deal. While this is sensible to preserve liquidity in this environment, ordinary dividends aren’t expected to be a sticking point. It’s FCA’s 5.5 billion euros special dividend that may cause problems. According to Tavares, the “time has not come to discuss this issue,” though it is widely speculated that it could be revised downwards in light of the downturn in the global auto industry. This may be a point of contention for FCA shareholders. Peugeot shareholders were also supposed to get PSA’s 46% interest in Faurecia SE in order to help achieve a merger of equals status. This interest was worth approximately 3 billion euros at announcement when the French auto parts company’s shares traded at 50 euros. Shares have declined to about 37 euros (as of July 27th), meaning PSA’s interest is closer to about 2.2 billion euros due to the pandemic.Regulatory HurdlesHaggling between the two companies over the appropriate compensation of this interest and the special dividend isn’t the only hang-up. FCA’s Italian unit had been in talks with Rome over a 6.3 billion euro state-backed loan from Intesa Sanpaolo (Italy’s largest retail bank) to combat the coronavirus crisis. Optically, a special dividend approaching this amount did not sit well, but the loan was ultimately approved. This was the largest crisis loan to a European carmaker. The state support should “preserve and strengthen the Italian automotive supply chain,” according to Economy Minster Roberto Gaultieri. FCA’s COO for Europe said “100% of the money this facility provides will be directed to our Italian business,” though neither side indicated whether any conditions surrounding the special dividend had been imposed.Europe is expected to be the main regulatory roadblock (or maybe more of a speed bump).While the deal has received the green light in the U.S., China, Japan, and Russia, Europe is expected to be the main regulatory roadblock, though executives have categorized it as more of a speed bump. In addition to earlier concerns in Italy about the special dividend, EU antitrust regulators began its investigation into the deal in June, citing potential to harm competition in small vans in 14 EU countries and Britain. So far, Stellantis has not offered any concessions. According to the European Commission, commercial vans are an “increasingly important market in a digital economy where private consumers rely more than ever on delivery services.” Through a joint venture, FCA and PSA already hold 34% of the van market in Europe. On July 22nd, the European Commission announced its probe had been suspended as the parties failed to provide requested information. The EU was originally supposed to offer its decision in mid-November, which has now been delayed.Will the Deal Happen?Though both sides are confident that the merger will go through as planned, there are clearly some details that will need to be tweaked throughout this process. Merger arbitrage traders usually provide a pretty good real-time view as to the likelihood of a transaction. For example, if a company is to be purchased at $50/share in cash, but shares are trading at $35, that means the market doesn’t think the deal will go through on those terms. However, the market’s view on the success of the FCA-PSA merger is nuanced. Arbitrage traders typically need to be able to short one side of the deal to execute their trade, but France has temporarily banned short-selling. Also, as an MoE, swapping stock certificates means both sides retain equity in the combined company, so share prices give different insight than an acquisition anyway. This means the share prices likely have more to do with the operating environment of the pandemic than the likelihood of the merger, though it may offer hints to what adjustments to the exchange ratio, special dividend, or Faurecia stock may be looming. Because the synergies are centered around cost-cutting measures, and regulatory hurdles don’t appear to be a deal backer, Stellantis will likely come into being if the two sides can hammer out the details.

Asbury-Park Place Acquisition as Seen Through a Monday Night Football Commercial

You Make the Call!

One of my favorite memories as a kid was watching Monday Night Football. Three things, in particular, stood out: the iconic introduction theme music, the “Game of the Week” feeling, and the IBM: You Make the Call commercial segment. Invariably at some point during the hotly contested game, the IBM commercial would be inserted. The announcer would narrate a controversial play and the highlight would run to a critical juncture, only to be paused and allow for the viewer to play armchair referee and guess the outcome or “make the call.” These commercials basically pre-dated instant replay review and the official’s ability to “go under the hood” to review the play and determine the proper outcome.With the revival and announcement of Asbury Automotive Group’s acquisition of the Park Place dealerships in Texas earlier this month, I was once again reminded of the IBM commercial.In this week's post, we review a timeline of the transaction, along with an analysis of Asbury’s stock price against the rest of its public competitors and also examine the operational strategy of Asbury over the years to explain aspects of the Park Place acquisition.As with any merger or acquisition, the true success or failure of the deal may not be known for years. Investors and industry professionals can try and play armchair quarterback and try to predict the outcome. This blog post aims to provide ample information so that you can “make the call” on the transaction.Transaction TimelineThe original transaction was announced in December 2019 and would include 19 franchise locations, one open point, two collision centers, and an auction business all located in the Dallas and Austin markets. Franchises included: Mercedes-Benz, Lexus, Jaguar, Land Rover, Porsche, Volvo, Sprinter, and five ultra-luxury (Bentley, Rolls-Royce, McLaren, Maserati, and Karma). At the date of the announced transaction, Asbury’s common stock traded at $122.67/share. On March 18, 2020, Asbury secured additional borrowings on its existing lines of credit and used vehicle floor plans. Recall that the first two weeks of March saw COVID-19 cases and the impact of shelter-in-place orders and other economic interruptions in the United States. At this point in the timeline, it still appeared that the transaction would continue, although Asbury’s stock price had already declined by a whopping 64% to $44.62/share. Just one short week later, Asbury terminated the Park Place transaction on March 25, 2020, citing the uncertain market conditions related to the COVID-19 pandemic. Interestingly, Asbury’s stock had rebounded slightly from the week before to trade at $58.67/share. Earlier this month, news broke that the Asbury-Park Place transaction was moving forward again on July 6. The auto industry had experienced some modest gains in the monthly SAARs for May and June, and this news was a shot in the arm for the auto M&A market. As more information has been released, the revised transaction with Park Place is scaled slightly lower from the original proposed transaction in December 2019. Terms of the revised transaction include the acquisition of 12 franchises, no open point, two collision centers, and the auction business. Pricing terms include total consideration paid of $735 million, excluding vehicles, reflecting $685 million of Blue Sky value on $95 million of EBITDA with $20 million in run-rate synergies. As I reviewed Asbury’s Q1 earnings call from earlier in the Spring, there were hints that this transaction might have still been in the works. At the time of the re-announcement, Asbury’s share price had increased to $78.41/share. In the two weeks following the announcement, Asbury’s share price increased by 25%. It appears that investors are excited by the revived transaction in the short run. We analyzed the historical trading prices of the other auto public competitors to determine how Asbury’s trends compared to the overall public auto market. While other public competitors (Lithia Motors and Sonic Automotive) have experienced larger rebounds than Asbury, the boost provided by Asbury’s transaction announcement has exceeded the gains by any other public competitor in that short time. It remains to be seen if investors will continue to show this level of enthusiasm in the months to come. Asbury’s Operational Strategy In its presentation to investors and explanation for the transaction, Asbury executives cited the following objectives: 1) conscious effort to acquire more luxury franchises, and 2) move out of less desirable markets and move into more favorable markets. Asbury management further postulated that luxury dealerships are more resilient than other franchises during market downturns, provide more stable margins, have less competition due to fewer dealers across the country, and maintain a higher portion of their gross profits from parts and service than other franchises such as import, domestic or mid-market.Let’s examine these objectives and play armchair quarterback with Asbury’s executive management. Since a large focus of the proposed transaction centers around luxury dealerships and their performance during economic downturns, we analyzed Asbury’s franchise platform from 2008 to present day. As much has been written in this space and in numerous industry pieces, perhaps the closest comparison to the present unstable economic conditions is the Great Recession in 2008 and 2009.Since 2008, Asbury has operated approximately 93 to 115 franchise locations in any given year. While the overall number of franchise locations hasn’t shifted too dramatically, the shift in dealership types can definitely be viewed following the additions from the Park Place transaction. As early as 2008, Asbury operated with only one-third of its franchises as luxury brands. Post-Park Place, Asbury’s brand mix will now be almost 50/50 luxury vs non-luxury. In addition to the brand shift, Asbury has also vacated several markets and entered into more favorable new markets. Specifically, Asbury has vacated Arkansas, California, and New Jersey. In recent months, Asbury has also divested of its Mississippi locations and one of its Atlanta Nissan locations, but has made an acquisition in the Denver, Colorado market. With the additional platform provided by the Park Place locations, Asbury’s focus will be on Florida and Texas as the two main sources of total revenue. Resiliency of Luxury BrandsIn order to test Asbury’s theories regarding the resiliency of luxury franchises against others during a downturn, we examined various financial indicators from public manufacturers’ from 2005 through 2012. For purposes of our analysis, we categorized the following as luxury brands: Audi AG, Bayerische Motoren Werke, Tata Motors Limited, Daimler AG, and Porsche Automobil Holding SE. We also compiled a sample group for other dealership classifications including import, mass market, and domestic. The results will be slightly skewed as several public companies overlap into multiple categories. Nevertheless, we indexed and measured the performance of the luxury brands to the other dealership groups by median revenue, gross profit, earnings before tax (“EBT”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”).Our study provided the following analysis of each financial metric indexed against a baseline median from 2005 data: [caption id="attachment_32683" align="alignnone" width="782"]Source: Capital IQ[/caption] For these indicators, luxury brands fared better than most other dealership groups but seemed to lag slightly behind import dealerships. Asbury executives will be banking on similar success and performance of their luxury brands as the auto industry continues to try and recover from the turbulent economic conditions caused by the pandemic.ConclusionsSo how will Asbury perform and will the revived acquisition of the Park Place dealerships prove to be successful? Only time will tell in the coming months and years.But for now, investors and industry professionals can hit the pause button and evaluate it just as viewers did with IBM's iconic commercials from Monday Night Football in the 1980s and “YOU MAKE THE CALL!”

June 2020 SAAR

A Lackluster Month, But a Move in the Right Direction

After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry. Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains. Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry. Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically, franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions. As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work. With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant. Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk. The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken. At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19 cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage. Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.

June 2020 SAAR

A Lackluster Month, But a Move in the Right Direction

Vroom, Zoom, and Stock Market Boom

As we teased last month, Vroom filed an S-1 with the SEC in May enabling its initial public offering (IPO) on June 9th. The online automotive retailer priced the 21,250,000 shares at $22/share. By the end of the trading day, Vroom’s stock had increased 118% to $47.90. For perspective, the NASDAQ as a whole rose only 0.3% that day.The company positions itself as “an innovative, end-to-end platform designed to offer a better way to buy and a better way to sell used vehicles.” A press release also touted its “contact-free” nature, apparently seeking to distinguish Vroom from traditional, franchised, brick-and-mortar dealers as COVID-proof.In this post, we consider Vroom’s business model compared to other online dealers, the company’s investment thesis that may have driven their spike, and see what the filing could tell us about the broader industry and the IPO market more generally.Drafting Behind CarvanaLeading up to an IPO, companies must put their best foot forward and offer plenty of promise. While being a futuristic company that uses buzz words like “data science” and “machine learning” sounds nice, will the benefit of an ecommerce boom ultimately be conferred on Vroom? We’ve previously noted this with Tesla. Despite being the buzz-worthy poster child, Tesla isn’t the only company with online retailing or electric vehicles. Carvana, Vroom’s most direct comparable in terms of online car retailing, IPO’d in 2017 and has about triple the revenue and gross profit margin. Carvana’s public life began with a rather inauspicious start; it opened trading at a 10% discount to its $15 IPO price and finished the day at $11.1 for a 26% decline. However, just over three years later, the stock is now trading 683% above its IPO price (as of June 26th). Carvana rode triple-digit quarterly revenue growth for 23 consecutive quarters, a feat unlikely to be duplicated by Vroom. However, Vroom is hoping their business model differences will be persuasive to investors.Vroom CFO Dave Jones acknowledges the similarities between the companies from the consumer perspective, but he emphasized their asset-light approach as something that materially distinguishes the two from an investment perspective. This approach has been taken in other industries, and such companies benefit from staying out of the fray when difficult operating environments depress margins. It remains to be seen whether Vroom will be able to navigate this effectively.Investment Thesis from the S-1Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles.While their asset-light approach helps distinguish them from Carvana, Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles. Vroom highlights industry fragmentation (42,000 dealers), millions of peer-to-peer transactions, and dissatisfaction with the status quo as reasons its ecommerce platform can continue to grow. The Company calculates the Used Auto market as the largest consumer product category with $841 billion sales on approximately 40 million units in 2019. This surpasses both Grocery and New Auto sales, which are $683 billion and $636 billion, respectively. Vroom pitches the current used vehicle business model is broken, with “limited selection, lack of transparency, high pressure sales tactics, and inconvenient hours.”Vroom also highlights the gross profit advantages inherent in used vehicles. From 2007 to 2009, the S-1 notes gross margins for new vehicles fell from 6.9% to 6.7%. Not only were gross margins higher for used vehicles, but they actually increased during these troubling times from 8.9% to 9.4%. While careful to explicitly make this forecast, Vroom heavily implies its ability to capitalize on COVID, a story that investors seem to be buying, at least for now.Financial Realities of VroomUnder “Use of Proceeds,” Vroom intends to use the $468 million in fresh capital (excluding certain underwriting costs) for general corporate purposes, including advertising and marketing, technology development, working capital, operating expenses, and capital expenditures. This should help fuel future growth as the company burns cash. Like many companies going public in recent years, Vroom is not turning a profit as it intends to “invest in growth to scale our company responsibility and drive towards profitability.” Advertising expense in 2019 was $72.5 million, which is 6.1% of revenue and more alarmingly, 125% of gross. With advertising consuming only about 40% of its SG&A expense in 2019, Vroom is spending about 3 times gross on SG&A. The company will be hoping that scale will eventually allow them to throttle back advertising spend without giving price concessions on its gross.A red flag for Vroom and its ability to draw future investors is its gross margin. In 2019, gross margin declined to 4.85%, down from 7.11% in 2018. While the company would likely point to its superior ecommerce margins of 6.1%-6.4% over the past two calendar years, it is notable Vroom’s gross margins are well below average margins (11.3%-11.4%) for used vehicle for these years. The asset light approach, one they have used to differentiate, may become a cause for concern as well due to the cost of outsourcing much of its critical operations.Future for Vroom, and Other Auto RetailersWill Vroom be able to carve out a place in the market? There are plenty of examples of duopolies such as Pepsi and Coke, Lyft and Uber, and Republican and Democrat. Uber and Lyft are hot auto-adjacent tech companies, but their service has been commoditized as many of its gig drivers opt to drive for both companies to increase their opportunities for trips and tips. The gig economy has spawned other fast-growing tech companies with many competitors in the food delivery space (DoorDash, Grubhub, Uber Eats, Postmates, etc.). Again, these companies have been forced to compete heavily on price despite not offering all of the same restaurants (not a complete commodity if you want a specific pizza only carried by DoorDash). Consolidation talks have already taken place in this industry, and it begs the question of how online auto-retailing will shake out. There are plenty of examples of tech subsectors having one giant player that is the go-to option for consumers (Amazon for online retail, Google for search engines, etc). Vroom, and the industry more generally, will be hoping that there are many seats at the table. For now, no single party owns more than 2% of the market.How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The S-1 highlighted ecommerce penetration in the industry sitting at just under 1%, compared to about 16% for total retail (thanks, Amazon). Vroom’s long-term value proposition likely hinges on your view of the future of car buying and the Internet’s role in the market. Consumers were forced online during recent stay-at-home orders, but will these necessary precautions breed long-term shifts? How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The ability to seamlessly browse across brands seems appealing, but traditional franchised dealership executives have voiced concerns over how much of the transaction can really take place fully online. Analysts have also frequently questioned the incremental costs associated with delivering cars and whether or not they are covered by the cost savings on retail. With its asset-lite approach, Vroom will provide a good case study.State of the IPO MarketAfter high-profile IPO flops in 2019, including Uber, Lyft, and WeWork (who couldn’t even make it to IPO), the tides appear to have turned in 2020 as exemplified by Vroom and to a lesser extent, Warner Music. Companies such as DoorDash, Lemonade, Airbnb, and others are looking at potential virtual IPOs, which may shed more light on whether Vroom was the anomaly or the precedent.Stock Market VolatilityCOVID-19 has led to significant market volatility with certain industries hammered (cruise lines, restaurants, and airlines to name a few) and others soaring (consumer durables such as cleaning supplies and virtual communication like Slack and Zoom). Speaking of the latter, a case of mistaken identity sent Zoom Technologies (ticker: ZOOM), a thinly traded Chinese wireless communications company, stock up 47,000%. Investors meant to be investing in the popular Zoom Video Communications (ZM), which has overtaken other platforms such as Skype as the dominant player during stay-at-home orders. Trading was halted to fix this issue, but this has not been the only curious case in the market over the past few months.COVID-19 has led to significant market volatility with certain industries hammered and others soaring.As a further example of the fluid, volatile nature of the current stock market, consider Hertz, the established rental car company. On the same day Vroom was publicly listed, Hertz saw its share price jump to $5.53. Yes, the same Hertz that filed for bankruptcy protection on May 22nd. The pandemic-induced demand shock on car rentals and air travel, that begets more rental cars, compounded years of problems including competition from ride-hailing services. The share price increase represented a nearly 900% rise from a May 27th low and an even more astonishing 80% higher than the day before it filed for bankruptcy protection. The sharp increase prompted Hertz to consider tapping the equity markets for one last bite at the apple. Despite the stock being theoretically worthless, the company was seeking to take advantage of the market’s exuberance after gaining bankruptcy court approval on June 12th. However, Hertz ultimately scuttled these plans as the SEC balked at the company’s filing which included a statement that the company’s shares could “ultimately be worthless.”There are theories abound as to what caused Hertz’ unfathomable increase. Central bank liquidity has no doubt fueled the risk-off mindset as the S&P index has increased nearly 35% since a March 23rd low (as of June 26th). The broader market reversal began when the Fed announced it would be buying individual corporate bonds, a promise they only started to make good on nearly 3 months later. Specific to Hertz, they appear to have benefitted, at least in part, from retail investors bidding up the price. As of June 15, data from Robintrack indicated more than 170 thousand Robinhood users held shares in the company. It was the #1 traded stock on the popular retail investor app that doesn’t charge commissions on trades. Some have taken it a step further to connect it to the dearth of gambling options with professional sports on hold. A more nuanced view might be that strategic investors are seeking to exploit the structure of the company’s debt. In the past, equity holders threatened to hold up the process, pressuring credit holders to pass on some of the value during bankruptcy proceedings. Hertz’ debt is largely held in asset-back-securities which fragments the voice of creditors and may ultimately weaken their bargaining power. While Hertz and Vroom are on the opposite ends of their time as a public company, each exhibit reasons to be wary of what the market might or might be telling private business owners.ConclusionSo, what does the stock price of Vroom mean for the value of my private dealership? Virtually nothing. While dealerships, like all businesses, require careful analysis in order to determine a reasonable indication of value, the value of your dealership probably did not double in a day. However, the public market does offer the opportunity to gain valuable insights from companies that operate all over the country. Vroom’s S-1 and successful IPO should signal what many dealership owners already know: digital platforms will become increasingly important, inherent margin advantages in used vehicle retailers are attractive, and growth captures the eye of investors.Contact a Mercer Capital professional to discuss the effect the dynamic auto dealership industry is having on your business today.

Valuation and M&A Trends in the Auto Dealer Industry

Shifting Out of Neutral

For this week’s blog post, we sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the recent release of their First Quarter 2020 Haig Report. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for each of the auto manufacturers based on their observations and data from participating in transactions in this industry.It’s still early on, but how does the economic disruption due to COVID-19 compare to the Great Recession in 2008/2009 on the auto dealer industry?KN: 2008 provided a great recipe for how to manage dealerships in a time of financial stress. But COVID-19 hit so quickly and with unprecedented shutdowns and associated reductions in sales volume and service revenue. The financial disruption was far more harsh in 2020 but there were some tailwinds that dealers didn’t have during the Great Recession. For example, almost 100% of lenders offered interest, principal and curtailment deferments immediately. PPP funds were available to most dealers and provided some necessary working capital. Interest rates were lowered to almost 0% immediately. And most OEMs got aggressive quickly with 0% deals for 72 and 84 months. SW: As Kevin alludes to, the biggest difference between 2008 and 2020 in navigating these troubling times is the assistance from OEMs. Industry bailouts were widely debated, and these manufacturers have been conscientious about being part of the solution this time around.What impact has the COVID-19 pandemic had on a) Blue Sky multiples, b) deal flow, and c) overall dealership value?KN: The pandemic has clearly impacted dealership operating performance and instilled some uncertainty around future earnings for the remainder of 2020 and even into 2021. In general, valuations have tended to recede approximately 10% but there are some dealerships that continue to attract pre-COVID 19 value due to franchise attractiveness and/or geographic demand. Buyers appear to be taking 2 different approaches – 1) they are utilizing 2019 and pre-COVID 19 2020 YTD results (i.e. historic performance) and then applying a slightly lower historic multiple to arrive at a moderately discounted value; or 2) they are utilizing unadjusted pre-COVID 19 multiples but against a forecasted 2020 and 21 earnings base that reflects a slightly lower expectation for income. Either way, it typically works out to about a 10% lower valuation. But again, some stores remain as or more valuable than before the pandemic. New transaction deal flow has been impacted in the short term simply because potential sellers have been fully engaged and focused internally on operating their dealerships during an unprecedented period of stress. They’ve been working on getting their PPP money, furloughing and rehiring associates, building a process to sell and deliver vehicles remotely, managing inventory, etc. We expect when the proverbial dust settles, there will be some motivated sellers who have experienced the Great Recession of 2008 and now the pandemic and will raise their hands and say enough’s enough. Additionally, the pandemic has further set in motion the need to have scale to compete in the new digital age of automotive retailing and some owners are recognizing it’s time to get big or get out. SW: Our valuation approach considers a broader analysis of historical earnings to estimate ongoing earnings. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year if neither are sustainable. Typically, forecasted earnings approaches were only utilized on start-up locations or early-stage dealerships where historical financials could not be produced. The economic impacts of the pandemic to the current year’s earnings will present a challenge to all valuation professionals. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Has any segment/classification of franchise (luxury, domestic, import, high-line) type been hit harder with regards to the impact of their implied Blue Sky multiples than others?KN: Higher value dealerships – luxury, very large dealerships or very high performing dealerships might experience moderately lower interest in the near term. This is strictly a function of capital availability as we wonder how many lenders are prepared to extend large amounts of credit on an expensive dealership. These types of stores generally have less risk and yield attractive valuations and will still be in demand but it may take several months of normalcy before buyers and lenders are ready to step up for an expensive BMW or Mercedes-Benz dealership as an example.Have you seen different effects on value in different areas of the country? If so, what are those differences?KN: The quantity and severity of COVID-19 cases and the related state shutdowns is partially correlated to valuations and demand for dealerships. Businesses in the northeast and California, where the pandemic hit hard and governors reacted with severe operating restrictions, have suffered far more than dealerships in the southeast and TX. The latter areas were able to operate, albeit with some restrictions, and sell and service vehicles more effectively. As a result, we’ve spoken with a number of dealers who’ve enjoyed record performance in May as states reopened and consumers took advantage of good weather, stimulus checks, and big OEM incentives. SW: In our discussions with clients, the severity of the impact on operations/earnings is also widespread. In addition to the pockets of the country mentioned by Kevin, we have noted dealers in Arkansas and Utah seem to have suffered less than other areas.Are there buying opportunities for larger auto groups, public companies, and those poised to be in the auto dealer market for the long-term?KN: Auto retail remains a highly attractive investment despite the inherent cyclicality of the industry. Dealerships can be very profitable and generate significant cash, further supplemented by the offshore and captive insurance companies many owners operate. Public companies, outside investment groups including PEFOs (private equity and family office investors), and well-capitalized private dealers have access to low-cost capital and are able to enjoy significant operational synergies. As the industry continues to consolidate and as the need for technical proficiency to master and innovate within the digital retailing sphere accelerates, buyers are going to continue to find opportunities to invest with strong returns.What is the profile of buyers and sellers that you’re seeing on current M&A deals?KN: For sure, a majority of buyers, particularly for the more attractive and valuable dealership assets are the consolidators, both private and public. They are pursuing opportunities to broaden their geographic footprint and franchise representation. Growth becomes a way to leverage both their cost structure over more stores but also to take market share through their improved processes, customer acquisition and retention strategies, and digital strength. Of course, smaller stores remain attractive to local buyers who want to expand their portfolio in their “backyard” or extend into nearby markets. Lastly, outside investor capital or PEFOs are again evaluating opportunities in this sector as they believe stores have some newfound upside with the recent reductions in performance. SW: Family office investors tend to have longer-term investment horizons than public/private consolidators. Additionally, family office investors present additional challenges as they often require more education, due diligence, and they also must bring a dealer principal/operator to the transaction or retain an existing person from the acquired company to assume this role. Once such a person is in the fold, bolt-on acquisitions become smoother and a platform can be created.What are your predictions for the auto M&A market for the remainder of 2020 and 2021?KN: We think 2Q 20 will again be slow as deals that were “inked” before or right at the beginning of the pandemic have been slow-walked to allow time for stability to return to operations. However, judging by the strong progress within our pipeline and conversations with other dealers and professional service providers, the back half of 2020 and 2021 should see some pretty strong transaction volume. Further, we anticipate some dealers will re-evaluate their future once they’ve had the chance to catch their breath from the shutdown and restart of business. This could include a full exit or a partial disposition of certain stores either to raise capital or eliminate some problem stores.What impact has the pandemic had on digital retailing vs. facilities/image requirements?KN: The concept of executing the purchase of a vehicle remotely had begun to gain some smaller degrees of traction before the start of the pandemic. However, a fully digital solution has received far more interest since consumers were forced or chose to transact as much of the vehicle purchase over their phone, tablet, or computer during the shutdown. Even home delivery has ramped up for both sales and service. Various surveys seem to indicate a digital end to end solution is becoming more desirable but a vast majority of consumers still want to come to the dealership for a test drive and thus complete the sale on site. We see those dealerships and groups who have the capital and sufficient intellectual horsepower to invest in digital solutions to be the winners over time. This is one more reason consolidation will continue. We are also hearing that OEMs are recognizing this trend and may soften their stance around upgrades of facilities, larger buildings, more acreage, etc. It’s a tough balance for dealers to have the best online solution and also invest millions of dollars to have the most extravagant and new building when fewer customers want to come to the store for both sales and service. SW: We tend to agree that these improvements appear to be declining as a value driver. We expect there to be more pressing needs for capital than facility upgrades, both from acquirors and dealer principals. These funds will go to consolidation efforts and shoring up finances coming out of the pandemic.What impact will the bankrupt rental car companies have on mitigating the sluggish used vehicle supply market?KN: It appears the bankruptcies of a couple of the large rental companies will restructure debt and equity, not necessarily eliminate operations. It allows the weaker operators time to weather the storm until rental activity ramps up. However, if the recovery goes slowly and business and vacation travel doesn’t pick up, you could see some permanent reductions in rental volume. That could impact nearly new used vehicles from supply in the coming years which are good sources of inventory for dealers and generally produce strong gross margins. What effect will the slowing down of new vehicle production supply from factory shutdowns have on auto dealer valuations and M&A activity? We believe tight inventories will be a short-term disruption that gets resolved over the next few months as production returns to normal. If you couple a big ramp up in production with lower new volume sales, dealer lots should get back to a steady state inventory level well before most current and any new transactions close. SW: Near-term supply will continue to remain a question as manufacturers cope with COVID outbreaks and the need to shut plants down for a day to sanitize. The stop-start nature may play a significant role in how quickly supply can ramp up.Do you anticipate that we will see a V, U, W-shaped recovery, or something else?KN: We are by no means economists and read the same data you and your clients see around the recovery expectations. It seems the consensus lies in the U or W recovery as it’s highly unlikely we immediately return to the low levels of unemployment pre COVID-19. Regrettably, too many businesses won’t reopen and certain industries that are large employers will be slow to recover. Think hospitality, transportation, entertainment, energy, etc. The near term improvement will occur far more quickly than the Great Recession comeback but it’s probably wishful thinking to believe we bounce back to past levels in just a couple of months. The good news is we have low rates, stimulus, OEM incentives and a strong banking sector to accelerate growth this time around. We thank Kevin Nill and Haig Partners for their interesting perspectives on the auto dealer industry. Industry participants are cautiously optimistic that retail sales, earnings performance and deal flow are trending in the right direction, but not without additional challenges. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

How Proper Normalization Adjustments Contribute to a Better Finished Product

Trusting the Process

"Head chef" in my family is a title and role that I not only enjoy but take very seriously. Like most folks, the last few months have created many more opportunities to refine my home cooking skills and sample different recipes and cuisines. My kitchen cooking repertoire has always exceeded my grilling capabilities. With the extra time at home, I decided to tackle the holy grail of grilling challenges: smoking a beef brisket. For those that have never tried, the brisket is one of the most intimidating cuts of meat to tackle. In addition to a million different temperature/time/technique recommendations, the brisket starts as a very tough piece of meat. It’s not uncommon to labor for 10+ hours smoking a brisket and still have it turn out like a leather shoe.After spending some time researching, I honed in on my process. This included preparing the brisket by trimming excess fat and cooking the meat at a higher temperature for a period of 4 hours or until the meat reached a certain internal temperature. The next step involved lowering the cooking temperature for another set of hours until the internal temperature of the meat reached an ideal 203 degrees. Not 200, not 205……203! The final step involved foiling or tenting the brisket in a dark, damp, confined space for a period of several hours, allowing it to rest and come to its final temperature. How’d it turn out? I’ll revisit that topic at the end of the post.Much like smoking a brisket, the valuation of an auto dealership is a process, and the client or intended audience for the valuation must trust the process (apologies to any Philadelphia 76ers fans that lived through the rebuilding years under Sam Hinkie).In previous posts, we discussed the valuation methodologies and the value drivers of an auto dealership valuation. The next step in the process is to normalize the financial statements.Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Adjustments are often interrelated; a change to the balance sheet frequently will affect the income statement as we’ll discuss. Some typical areas of potential normalization adjustments in the automobile dealership industry include, but are not limited, to the following.Balance SheetInventoriesMost automobile dealerships report the value of their new and used vehicle inventories on a Last-In, First-Out (“LIFO”) basis. LIFO accounting allows the dealership to reduce the value of their inventories and pay fewer taxes. General valuation theory calls for inventories to be restated at First-In, First-Out (“FIFO”) basis. The FIFO adjustment affects both the balance sheet and the income statement. On the asset side of the balance sheet, we add the LIFO reserve amount to the reported LIFO inventory, raising the value of the inventory. Liabilities also increase due to the additional taxes that would be paid on a FIFO-equivalent inventory, calculated as the LIFO Reserve multiplied by the corporate tax rate. We will discuss the income statement impact later. Fixed AssetsFrequently, dealers own everything in two separate, but related entities. One entity owns the operations of the dealership and other owns the underlying real estate. In those cases, most dealerships still report some cost value of land or leasehold improvements on their factory dealer financial statements. The business valuation expert must determine who owns the real estate, and if not owned by the dealership, the value of the land and leasehold improvements needs to be adjusted/removed. This adjustment reflects the true value of the tangible assets of the dealership. Failure to properly assess and make this adjustment will skew the implied Blue Sky multiple on the concluded value for the dealership. Working CapitalMost factory dealer financial statements list the dealership’s actual working capital, along with the requirements from the factory on the face of the dealer financial statement, as seen in the graphic to the right. It’s important for the business valuation expert to assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital are not always rigid. An understanding of the auto dealer’s historical operating philosophy can help determine whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of the factory requirements. Goodwill/Intangible/Non-Operating AssetsOften auto dealers might have intangible and non-operating assets such as goodwill from a prior acquisition, cash surrender value of life insurance, personal seat licenses ("PSLs"), excess/non-operating land, airplanes, etc. These assets do not contribute to the cash flow from operations and/or are not included in the tangible assets of the business. Blue Sky multiples inherently capture the intangible value of a dealership’s expected future earnings. The appraiser must remove goodwill and intangibles on the balance sheet to establish the tangible asset base of the dealership before any application of a Blue Sky multiple. Owner Accounts Receivable Occasionally, auto dealers loan money into the dealership with no intention of ever repaying those funds, and dealers sometimes misplace or disguise items on the dealer financial statement to overstate working capital. Valuation analysts have to ask about these items specifically during their management interviews with the dealer principal or controller to know if adjustments to the dealer financial statement are warranted. Income StatementInventoriesAs discussed earlier, the use of LIFO inventory systems creates normalization adjustments on both the balance sheet and the income statement. On the income statement, the inventory adjustment affects the cost of goods sold (“COGS”), and ultimately, the gross profit margin. The shortcut method to the adjustment analyzes the change in the LIFO reserve year-over-year. If the LIFO reserve increases, the resulting normalization adjustment decreases COGS and increases profits. Conversely, if the LIFO reserve decreases, the resulting normalization adjustment increases COGS and decreases profits. Officers’/Dealer CompensationLike all valuations, the compensation of the officers’/dealer principal must be considered for potential adjustment. Typically, a business valuation expert will review actual compensation paid and determine a replacement or market equivalent compensation level; experienced business valuators in the auto dealer industry have techniques and benchmarks to determine a reasonable replacement cost. In addition, some auto dealers have non-active employees or family members on the payroll. The salaries of non-active employees also must be normalized by adding back those expenses as they would not be included for a public equivalent.RentAs noted previously, the underlying real estate utilized by the auto dealer is frequently owned in a separate, related entity. As such, the dealership pays rent to the related party entity. The business valuation expert needs to determine if the rental rate paid is equivalent to a market rental rate. Often, this rental rate creates additional profitability at either the dealership entity or the real estate entity. Experienced business valuators in the auto dealer industry have several techniques and benchmarks to determine a fair market rental rate for the facilities.Other Income Items Most factory dealer financial statements have a line item on the income statement for other income items/additions. This category can be sizeable for a dealership depending on its sales volume and level of profitability. It’s important for a business valuator to determine the items that comprise this category and how likely they are to continue at historical levels. Some common items that appear in this category include factory dealer incentives on sales volume levels for vehicles, factory dealer incentives for service performance, document/preparation fees on the sale of new and used vehicles, and additional costs for financing and other services sold as a part of the vehicle transaction ("PACKs").Discretionary/Non-Recurring/Personal Expenses Like all valuations of privately-held companies, auto dealership valuations should normalize all expenses that are discretionary, non-recurring, or personal in nature. Often, these expenses can be determined during the management interview phase of the business valuation.Expected Industry Profitability vs. Actual Profitability The valuations of auto dealerships are also unique in that underperforming stores can often be more “valuable” than stores performing at or above the market from a multiple perspective. One reason for this phenomenon is that hypothetical buyers recognize the improvements they can make to profitability for underperforming stores. Experienced business valuators in the auto dealer industry know to consult expected industry profitability levels depending on the manufacturer, geographic region, and competition. Expected profitability levels can be an added benchmark to the totality of the other normalization adjustments determined in the valuation process.ConclusionsJust like the cooking technique with the brisket, the process of normalization adjustments and the overall valuation is a roadmap for advancing from the start of the engagement to a finished conclusion. Skipping any steps along the way in the process will lead to a flawed/incomplete valuation conclusion, or a leather shoe of a brisket. I’m happy to report that trusting the process with smoking the brisket resulted in a happy family and a tasty/tender dinner!We have highlighted many of the typical normalization adjustments that must be considered in the valuation of an auto dealership. With the many nuances that must be considered, hiring a business valuation expert that specializes in this industry rather than a generalist business appraiser can make all the difference in providing a reasonable valuation conclusion.

May 2020 SAAR

May Vehicle Sales Supported Optimistic Predictions, But a Slow Manufacturing Rebound is Threatening to Hinder This Growth

May ReopeningsMay brought some hope of a return to normalcy with most states easing lockdown restrictions and stay-at-home orders. With this easing of orders, businesses were optimistic that their economic struggles may be alleviated as their customers could finally return. However, the effects of shutting down an entire global economy do not go away as soon as lockdowns end with major supply chain disruptions contributing to bottlenecking and inconsistent inventories. This issue will be prevalent across many industries and auto dealers won't be exempt. The industry will be impacted by manufacturing slowdown problems.May SAAR UpdateAfter a devastating April SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks), predictions for a rebound in May proved to be correct. Vehicle sales in the month jumped with SAAR increasing 38.6% to 12.2 million. Though this was a 29.7% decline from May 2019, the uptick from April and March numbers point to a recovery. Dealers are hopeful that April was the lowest the SAAR would reach, and with this new data, feel greater confidence in their predictions.May vehicle sales jumped with SAAR increasing 38.6% to 12.2 million.As we mentioned in our April SAAR post, many of these sales reflected dealers embracing online technologies and incentive programs to get cars out the door. Recently released data for May from Edmunds.com showed that the annual percentage rate (APR) on new financed vehicles averaged 4% last month. This was a drop compared to the April average of 4.3%. More strikingly, however, was the difference from the year-ago average of 6.1%. May’s 4% rate is the lowest average interest rate since August 2013.While auto dealers were able to use different methods to increase sales, factories that supply auto parts and cars did not have such flexibility. The reopening of plants for General Motors, Ford Motor, in mid-May came after an almost 2-month production hiatus. Furthermore, though plants have begun reopening, they are not running at full capacity. Jamie Butters, Chief Content Officer of Automotive News, noted that disruptions in both Mexico and the U.S. manufacturing industries from the virus and social distancing measures threatens to cut the flow of vehicles and vehicle parts. According to a report from industry research firm LMC Automotive, fewer than 9 million vehicles are expected to be produced in 2020, the lowest since 2011 when an earthquake in Japan disrupted the global supply chain. If volumes are going to snap back like some have forecast, this will either require a pivot to used vehicles, or an increase in the expectations for vehicle production.Dealership Inventory HeadwindsEven if auto dealers wanted to reopen their dealerships at 100% capacity, they need the pipeline of inventory to do so. Dealers who liquidated inventory (sometimes at fire sale prices) may have trouble sourcing popular models if production can’t ramp back up quickly enough. As the Lansing State Journal notes, “Every vehicle that is sold is a catch-22 for the industry. Every sale depleted inventory but with manufacturing all but frozen those inventories could not be replenished.”According to data from the BEA, April saw an inventory-to-sales ratio of 3.6, its highest level since February 2009. This likely says more about severely depressed sales than any excess in inventory. Prior to the pandemic, this ratio was actually below 2.0 for four consecutive months, a figure that has only occurred twelve times since 2000. Although BEA data for May inventory has not been released yet, according to Motor Intelligence, new-vehicle U.S. inventory fell 32% in May, to about 2.6 million, the lowest in recent years. Among the vehicles in the shortest supply are large pickup trucks. In a research note Monday, Barclays warned of a “critical risk of supply shortages” of large pickups, estimating dealers had only 44 days of inventory before running out of models such as the Ford F-150 and GM’s Chevrolet Silverado. The truck stock is half of what it was earlier in the year.Barclays isn’t the only bank focused on inventory. John Murphy of Bank of America asked all of the public auto dealers about the potential for short inventory in the summer months, and many acknowledged the potential for shortages. Below are some select quotes regarding the topic from the earnings call:“At the end of March, our total new vehicle inventory was $861 million, and our day supply was 105, up 18 days from the prior year. In April, we were able to drop our new car inventory approximately $120 million from March 2020. While these levels may seem high, because the OEM factories have been shut down, we believe we could run into a low day supply for the summer selling season. […] in some of our luxury and some of our domestic specifically, we could run into a lower day supply of some of the models.” –Dan Clara, SVP Operations Asbury Automotive Group“But I think we're going to have a big issue on incoming inventory from all the manufacturers. You've seen the German manufacturers starting and then stopping from the standpoint of a new production. I know from Daimler's perspective in Mexico. They pushed off heavy duty trucks like two months. It's not the fact that they don't want to open or not meeting the protocols in the plant is the fact that the supplier base -- in the old days, maybe back in '08 and '09 at least OEMs are more vertical from the standpoint of the supplier their parts for their vehicles. That's not the case today. So, they have to rely on many, many suppliers and I think that's going to be key.” – Roger PenskeRental Company DeclineRental car bankruptcies could result in a high number of used cars diluting an already crowded used car market.A decline in the rental car industry may compound the problem. In late May, Hertz and the parent company of Advantage Rent A Car filed Chapter 11 bankruptcy due to debt and global travel being wiped out from the COVID-19 pandemic. New vehicle sales to rental car companies accounted for about 10% or 1.7 million vehicles last year. That demand came to a screeching halt due to the COVID-19 pandemic, and some analysts expect no more than 250,000 such sales in 2020. While the disruption in the rental car industry most directly impacts automakers, used car dealerships could find themselves in trouble as well. With downsizing expected among restructuring efforts, the rental car bankruptcies could result in a high number of used cars diluting an already crowded used car market and impacting overall used car prices. Although this may mean a good deal on a vehicle purchase for consumers, trade-in values would decrease and lower values could damage auto brands and impact newer model pricing.Despite the prospects of inventory shortages and used vehicle surpluses later in the summer, as long as there is not another major disruption to the supply chain and travel, these issues may not be long lasting. As Chris Holzshu of Lithia Motors noted in their earnings call, “Once the ramp up starts, it takes about 30 days for a vehicle to get completed on the production line and make it to one of our stores.” Though a month of disruption is not ideal, it can be managed. Dealers will hope to get through short supply by nudging customers towards less in-demand models. As travel picks up in the future, rental car companies can expect to see increased activity and thus, less saturation of the used car market.ConclusionWhile the rest of the country began to try to start fresh after months indoors, I decided that I needed a change in my own household as well in the form of an Australian Shepherd puppy. As you can see, Bobby loves Mercer Capital and the auto dealer industry team just as much as I do. We follow SAAR and other key industry trends to gain insight into the private dealership market. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to us.

Driving Value: Key Components of an Auto Dealership Valuation

As a lifelong, avid sports fan, the lack of live sports over the past few months has created a huge void. In their absence, I have enjoyed watching the replays of several classic, iconic games from my childhood and teenage years: the 1986 World Series Game 6 aka the “Bill Buckner game,” the 1992 Elite 8 matchup between Kentucky and Duke aka the “Laettner Shot,” and the 1992 NLCS Game 7 between my beloved Atlanta Braves and the Pittsburgh Pirates aka the “Sid Bream Slide game” among others. The replays have been fascinating for the memories and emotions that they evoke, but it’s also interesting to see the finer details that had been lost or blurred from my memory over time. And yes, Buckner still missed the ball, Laettner still hit that miraculous shot (unfortunately), and Sid Bream was still safe! But what made these games iconic and have the classic value over time that they still do today?The appreciation and ultimate value of an auto dealership is impacted by several key value drivers.All of them had certain ingredients that were “controllable.” An Elite 8 or playoff game will always have greater stakes than a regular season game, and playoffs tend to have greater talent at a higher level of competition. It also just means more when it’s your team. And rivalries will always up the ante. These situations increase the likelihood of a game becoming a classic, but I also realized the games I rewatched had other uncontrollable components that contributed to their value – pressure moments, unlikely heroes like role players stepping up, and the never-ending spirit to keep competing until the final out or buzzer.Just like these classic sporting events, the appreciation and ultimate value of an auto dealership is impacted by several key value drivers. Some of these value drivers are controllable or able to be affected by the owner, and some are outside of their control.Auto dealers, like most business owners, are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are various life events that make them need to know the value such as a transaction (including buy-sell), litigation, divorce, wealth-transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and focusing on the value drivers of their auto dealership and addressing them on a consistent basis. So, what are some of the value drivers of an auto dealership?FranchiseAn auto dealership’s franchise affiliation has a major impact on value. Each franchise has a different reputation, selling strategy, target consumer demographic, etc. Public value perception of franchises tends to be unique and are most easily illustrated through Blue Sky multiples. As the Haig Report and Kerrigan’s Blue Sky Report indicate, Blue Sky multiples vary over time even if they are frequently stagnant from period to period. Often auto dealerships and franchises are grouped into broader categories, such as: luxury franchises, mid-line franchises, domestic franchises, import franchises and/or ultra high-line franchises. Dealers may not have significant influence over the value perception of their franchise, making this value driver appear “uncontrollable.” However, dealers do have the opportunity to make bolt-on acquisitions and expand their operations to more rooftops. This will likely improve foot traffic to the various franchises in general and ultimately may improve the value of the business, particularly if they are able to appropriately decide which franchise to add.Real Estate/Quality of FacilitiesTypically, most dealership operations are held in one entity, and the underlying real estate is held by a separate, often related entity. Several issues with real estate can affect an auto dealership valuation. First, an analysis of the rental rate and terms should be performed to establish a fair market value rental rate. Since the real estate is often owned by a related entity, the rent may be set higher or lower than market for tax or other motivations that would not reflect fair market value. Second, the quality and condition of the facilities are crucial to evaluate. Most manufacturers require facility and signage upgrades on a regular basis, often offering incentives to help mitigate these costs. It’s important to assess whether the auto dealership has regularly complied with these enhancements and is current with the condition of their facilities. Owners seeking to drive value can do their part in making sure their facilities are up to date and appealing to customers.Due to the coronavirus pandemic, facility upgrades may become less of a value driver. Stay-at-home orders have forced consumers to buy automobiles through more automated means. While dealers have long touted their omnichannel offerings, the pandemic has put them to the test. The shift to digital platforms is expected to decrease foot traffic to the actual dealership. With the focus moved away from the dealer’s real estate and physical showroom, the importance of the latest and greatest signage is likely to be diminished. It’s possible that the quality of a dealer’s facilities may become less of a value driver if consumers are less dependent on those facilities.Employees/ManagementThe quality and depth of management can have a positive impact on an auto dealership valuation. Auto dealerships with greater management depth and less dependence on a few key individuals will generally be viewed as less risky by an outside buyer. Also, an auto dealership’s CSI (Customer Service Index) and SSI (Service Satisfaction Index) rating can influence incentives from the franchise and the overall perception of the consumer. A strong CSI and SSI are reflections of a strong service department and a commitment to quality customer service. While franchise customer service figures are not controllable, owners can make sure their employees provide consistent, exemplary customer service which will boost reputation and drive value.Recent Economic PerformanceLike most industries, the auto industry is dependent on the national economy. The auto industry measures and tracks sales of lightweight automobiles and trucks in a Seasonally Adjusted Annual Rate (SAAR), which is an indicator of historical economic performance in the auto industry. In addition to monitoring and understanding the current month’s SAAR, the longer-term history of the SAAR and its trends also provide insight into the auto industry and an auto dealership valuation. Below is a long-term graph of the SAAR over the past 20 calendar years:While dealerships tend to ebb and flow with the general economy, the industry can also be cyclical based upon the average age of cars owned. Consider a period with significant volumes over a number of years. Because cars are typically owned for several years, these customers are not repeat customers except to the extent they visit the parts and service departments. All else equal, periods with high volume sales tend to be followed by lower volume periods. As you might expect, dealers have minimal influence over these cycles. Like the bottom of the 9th in Game 7 of the World Series, it’s just going to mean more.Buyer DemandBuyer demand in the transaction market can illustrate the value climate for auto dealer valuations. Typically, buyer demand is measured by the deal activity in the M&A market. The Haig Report indicated that 2019 was another strong year for the buy-sell market after a sluggish beginning. They estimated 78 stores were acquired by public and private buyers in Q42019 alone. Similarly, Kerrigan’s figures also illustrate a strong buy-sell market for 2019 after a slow start. Kerrigan notes 2019 was the strongest year for transactions since 2014. Increased buyer demand leads to higher multiples and ultimately valuations for dealers. While this is not something that dealers can directly influence themselves, adhering to the other aspects noted in this piece can increase the likelihood dealers receive a favorable multiple.Buyer demand and M&A activity will be severely affected in 2020 as the buy-sell market has largely been placed on pause due to the economic conditions and stay-at-home mandates related to COVID-19. Again, this is largely out of the dealer’s control, though they can take steps to make their dealership more attractive.Location/MarketThe value of an auto dealership can be more complex than urban vs. rural or major metropolitan city vs. minor metropolitan city. Each store location is assigned a certain area or group of zip codes referred to as an area of responsibility (AoR). Particularly, how does a location’s demographic characteristics line up with a certain franchise? For example, a high-line auto dealership would perform better and seemingly be more valuable in a major metropolitan area with a high median income level, such as Beverly Hills, California, or South Beach in Miami than in a mid-western city. Conversely, a mid-line Store would probably fare better in areas with more moderate median income levels.We’ve discussed how the national economy can affect an auto dealership’s value, but in some instances, performance can also be greatly influenced by its local economy. Certain local markets are dominated by a particular trade or industry. Examples can be auto dealership locations near oil & gas refining areas, mining areas, or military bases. For example, there may be an influx in car sales as members of a particular base are deployed or return home. In such instances, a dealership is probably more dependent on local economic conditions than national economic conditions. This is where it is key for owners to recognize the environment in which they operate and tailor their operations to maximize these opportunities. Like Steve Kerr said when Michael Jordan was double-teamed in Game 6 of the NBA Finals, “I’ll be ready.”Single-Point vs. Over-Franchised MarketThe amount of competition in an auto dealership’s AoR, as well as the nearest location of a similar franchised auto dealership, can also have an impact. It’s important to make the distinction that we are talking about a single-point market and not a single-point dealership. A single-point market refers to a market where there is only one auto dealership of a particular franchise. An over-franchised market would be a larger market that may contain several auto dealerships of a particular franchise within a certain radius. Often, an auto dealership in a single-point market would be viewed as more valuable than one in an over-franchised market that would be competing with its own franchise for the same consumers. Additionally, the auto dealerships of the same franchise in the same market could be drastically different in size. One may be part of a larger auto group of dealerships, while the other may be a single-point dealership location, meaning that owner only owns that one location. A dealer with one of many Ford dealerships in a city, for example, is likely to be worth less because customers going to buy a new Ford have many convenient options. Additionally, a dealer with a single-point franchise is likely to lose out on customers that aren’t sure what make or model they want. If they only offer vehicles from one franchise at their location, they may draw less foot traffic due to less variety. We’ve already discussed how certain brands tend to receive higher Blue Sky Multiples and how that should factor into acquiring a new franchise. Owners looking to enhance the value of their dealership operations should also consider the saturation of franchises in their market. While a Lexus dealership may have a higher Blue Sky multiple than a Kia, if there are no other Kia dealerships in the market, they may be able to earn more in profits. Improving earnings are an easier way for owners to improve the valuation of a dealership as multiples tend to represent other uncontrollable market influences.Conclusions and ObservationsAs we’ve discussed, the value of an auto dealership is influenced by a variety of factors. Some of the factors are controllable, and some are external. Just like a classic sporting event, auto dealers have to focus on what they can control, hoping to create value and maintain or grow it over time.To find out the value of your auto dealership today, contact one of the automotive industry professionals at Mercer Capital. Whether or not you may have an upcoming life event that may necessitate a valuation, we can help you understand your progress and further understand our process. That way, when it comes time, you’ll be ready.

Q1 2020 Earnings Calls

COVID-19 Causes Declines in Q1, but Executives Maintain Optimism Going Forward

Auto dealers stock prices declined in the first quarter of 2020 following the broader market trend. Though many dealers saw year-over-year gains in sales and earnings in the first two months of the year, earnings calls focused on the coronavirus pandemic. Volumes have fallen across the country, though executives pointed to recent positive trends. Downturns have muddied the M&A market, and some companies don’t plan to rehire everyone that has been let go. Many praised the support of OEMs including significant incentives such as 0% financing. With dealership doors shuttered, many executives touted their online presence, though there was not a consensus on digital’s long-term place in the market.CarMax (stock price -4% year-to-date May 26th) and Carvana (+48%) have performed better than traditional franchised dealers (-23% on average), pointing to the strength of this business model during this time. Vroom, Inc., another online used car seller, even filed for an IPO despite the significant macroeconomic headwinds and recent poor performance of auto-adjacent tech-company offerings. If the offering occurs as scheduled and performs well, this bodes well for AutoNation, who owns about 7% of the company after a $50 million investment in late 2018. In mid-April, AutoNation granted its CEO, Cheryl Miller, a leave of absence for health reasons. They also returned their PPP loan well before the Safe Harbor Deadline (most recently postponed to May 18th) due to shifting guidance about eligibility. It should also be pointed out that their eligibility as one of the largest auto dealers in the country drew ire from the public.AutoNation wasn’t the only public auto dealer facing its own issues amid the market turbulence. Asbury scuttled their $1 billion Park Place transaction, which included $10 million in damages, not counting other expenses incurred related to due diligence and financing. This would have been one of the largest transactions in the auto dealer space in years. Penske waited until after their earnings call to announce they were cutting their dividend, “consistent with the other measures the company has implemented the impact of COVID-19.” The S&P 500 has rallied significantly from March lows due to significant liquidity injections and optimism of a quick “V-shaped” recovery, but there may be more room for it to fall if more companies like Penske and Group 1 have to cut dividends.Theme 1: April was the worst month for national sales volumes in decades. However, recovery has been evident on a weekly basis even throughout April as companies ramp up their digital capabilities.In the U.S., our workshops have generally remained open, unlike many of our showrooms, but the flow of service customers has been down 40% to 50% since mid-March, simply because most of our customers have been living under shelter-in-place orders. The closure of most of our U.S. showrooms since mid-March has reduced new and used vehicle sales by a similar percentage. […] As April progressed, we began to see some rebound in our week-over-week sales base in the U.S. market. For the final week, retail unit sales were down approximately 25%, and service revenues were pacing about 30% lower than prior-year levels. -Earl Hesterberg, President and CEO, Group 1 AutomotiveDuring this period, our overall vehicle sales volumes fell roughly 40% compared to the prior year. […] In the past week though, the year-over-year vehicle sales declines have improved to roughly 30%, with used vehicle sales being slightly more resilient than new vehicle sales. Parts and service gross has also improved over the past week as states begin to relax their stay-at-home orders and customers begin to return for delayed repair and maintenance work. -David Bruton Smith, CEO and Director, Sonic AutomotiveTheme 2: Coronavirus has accelerated the push to digital, resulting in heavy investment which means online shopping will continue beyond the pandemic. However, some executives believe consumer preferences and their (lack of) understanding of financing options will continue to be roadblocks to fully online.I think that [digital] trend was already underway where the value of a brand and experience and a warranty/guarantee has all been expressed as a consumer of things that are valued and there’s been a movement towards companies like AutoNation with One Price, CarMax, Vroom, Carvana. […] I think for digital, this whole disruptive period with corona is an inflection point from which there’s no turning back. […] You need first-class digital capability; you need a safe environment for your customers and a safe environment for your associates. That is the Holy Grail going forward. We see no difference in profitability between the digital channel and the traditional challenge whatsoever. -Michael Jackson, Chairman and CEO, AutoNation[W]e believe that about half of the consumers today would really prefer to be able to buy cars in the comfort of their own home. We are seeing though that there is still many of the consumers and we’ve narrowed it down that we think that about 20% of the consumers have the ability to [complete the car buying process] by doing it digitally and doing it all from home without human interaction. The other 80%, we really believe even though they want to that’s the biggest impediment not the desire, but consumers just don't have the ability. -Bryan DeBoer, President and CEO, Lithia MotorsA lot of customers that come in whether they don't know what they're looking to acquire, they don’t know the kind of vehicle that they want for their family or they have some financial issues. As we’ve said before, you know, our average consumer has $5,100 of negative equity that they’re working to, you know, leverage our finance specialists to help them find the right solutions for them. -Chris Holzshu, EVP and COO, Lithia MotorsTheme 3: Auto dealers cut headcounts to manage SG&A expenses, but not all these jobs will return when markets stabilize due in part to digital. Some are optimistic they will bring everyone back, and most directly relate rehiring to the rate at which business returns.I don't know that [headcount related cost saves are] near-term, I think what we have to do is understand what will be the footprint of our business. How much will be digital? How much will be done from home? How many people we have actually working in the operations? […] As we see the number of people we have furloughed and as a business going [forward will] be decided by how business comes back. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe didn’t furlough any technicians. Because of our cash position and how we manage our expenses [the quarter could have been better] had we just cut the normal expense as you would in a typical recession. We believe that this was going to be temporary. And eventually, the business was going to come back. […] we have strong metrics that will dictate to us when we bring people back. And when we see those metrics starting to be achieved, we’ll certainly bring people back at that time. The folks that we’ve furloughed, we communicate with them consistently, and we were hopeful one day to bring them all back. -David Hult, President and CEO Asbury Automotive GroupWe’ve bought back 1,000 associates thus far, meaning that our staffing reduction is around the same as the business reduction. There is no predetermined cadence or plan as to when we bring back additional employees. […] [I]f I look back to 2008 and 2009, I would observe re-staffing trailed the improvement in business. […] And what other efficiencies and effectiveness around digital is figured out or we come to grips with, whether that leads fact that we hire everyone when we ultimately have a full recovery in our back, well, I can’t answer that today, other than I can say, rehiring will trail the growth of the business. -Michael Jackson, Chairman and CEO, AutoNationTheme 4: M&A has been delayed or canceled due to the coronavirus as buyers aren’t willing to pay what sellers want with earnings deteriorating. Executives believe consolidation will ultimately resume and companies focused on maximizing liquidity may be best positioned for such acquisitions.As we saw business decline, we acted decisively to fortify our business to prepare for the inevitable slowdown. Unfortunately, this included canceling the Park Place acquisition […] we thought the Park Place deal was going to be a transformational deal for us, and it was a heck of an acquisition, but things happen. On the other side of that coin, we’re sitting on a lot of cash and probably the lowest net leverage ratio we’ve had. […] I think we need to see the dust settle a little bit. There is some activity out there. […] I don’t want to comment on [reengaging] the Park Place transaction. But we feel like from a cash position and where we’re sitting operationally, we have the ability to be very flexible and being acquisitive when the right opportunities come. -David Hult, President and CEO Asbury Automotive GroupI think it's going to be brand-by-brand where you have your strengths and also we have scale where you can consolidate some of the fixed costs, but I think it's too soon to look at that. […] We would focus [capital allocation] today, probably investing in the used car business from the superstore perspective and also look at expanding our footprint get on commercial trucks side. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe need to verify earnings quality that they’re within that 90% to 95% earnings level of what they were pre-COVID-19. So, those earnings quality verifications will determine the second half closing date or possibly even beyond that in the event that earnings quality hasn’t improved. There are chances that if earning quality doesn't improve then we would actually renegotiate the transaction in terms of the goodwill amount as well. -Bryan DeBoer, President and CEO, Lithia MotorsOur liquidity position, for us, is about as strong as it's ever been. So as we come out of this, we do believe there's going to be some M&A opportunities for us -Jeff Dyke, President, Sonic AutomotiveSummaryEarnings calls this quarter were uniquely positioned. Despite much of the financial impact occurring in Q2, the demand shock caused by the coronavirus was so severe that many dealers saw a decline in Q1 figures. While things are expected to get worse in Q2, there is optimism as numbers continue to improve on a weekly basis. Still, it should be noted that volumes are becoming less negative, not reversing to positive in most instances. Hopefully trends will continue their positive trajectory by next quarter’s calls. Tough times are ahead for public and private dealers, but current investments in digital strategies may lead to some long-term benefits as a silver lining to this difficult situation.At Mercer Capital, we follow the auto industry closely in order to understand not only recent trends, but how investors ascribe value to the public dealerships. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, reach out to one of us, and we’d be happy to chat via telephone, email, Zoom, or whatever your preferred communication in this dynamic digital age.

April 2020 SAAR

April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR

April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders. April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May. SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic. NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains. With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery. Kentucky and Hawaii were also among the last states to ease online restrictions. Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time. One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market. During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop. With less than a 50% decline, dealers in America are faring better than expected. How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months. With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions. A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits. To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing. Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day We assumed a depreciation cost associated with the vehicle sitting on the lot. Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.” For illustrative purposes, we settled on a $100 a day depreciation cost. The following charts show a summary of the results from three present value calculations. As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments. If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494. That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront. May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May. Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels. Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].” Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April. Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused. It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.

April 2020 SAAR

April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR

Complex Valuation Issues in Auto Dealer Litigation

Solving the Puzzle

Litigation engagements are generally very complex, consisting of many moving parts. The analogy that comes to mind is the nostalgic game of Tetris. While invented in 1984 by a Russian named Alexey Pajitnov, most of us remember the iconic version popularized through the Nintendo Gameboy in the 1990s. The game featured seven game pieces cascading down at increasing speed forcing the game player to manipulate them by rotating and placing them, trying to create a flat surface. As anyone that has played can attest, the game creates more anxiety and stress as the pieces cascade faster and begin to pile up.Like the game, many clients involved in auto dealer valuation disputes also experience anxiety and stress as problems begin to pile up. When assisting these clients in our family law and commercial litigation practices, we strive to help alleviate the pain points, or “clear the blocks.”We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes.The following topics, posed as questions, have been points of contention or common issues that have arisen in recent litigation engagements. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.We begin with seven questions to represent each of the original Tetris pieces, and we’ve added two questions to consider additional issues raised during the COVID-19 crisis.Should Your Expert Witness Be a Valuation or an Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts – one for the plaintiff and one for the defendant. In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry. It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques. Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)1 or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples. Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy. Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy. The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer. For example, a luxury or high-line franchise in a smaller or rural market would not be expected to fare as well as one in a market that has a larger and wealthier demographic. In certain markets, an understanding of the local economy/industry is more important than an understanding of the overall auto dealer industry and national economy. Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the dealership. If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon? Many of the corporate entities involved in litigation have sophisticated governance documents that include operating agreements, buy-sell agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigation, the focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value. However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers. Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document? These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. If they’ve never been used, and don’t conform to accepted valuation methodologies for auto dealers, then how reliable can these be? Additionally, some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney. Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an automotive dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation. An important consideration is the motivation of the buyer and seller in these internal transactions. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation. What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing. The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, the stated value by the dealer principal on their personal financial statement provides another data point to valuation. One view of a personal financial statement is that no formal valuation process was used; so at best, it’s a thumb in the air, blind estimate of value of the business. The opposing view would say the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in a document under penalty of perjury. Further, some would say that the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business. While they are not business appraisers, they are instrumental to a valuation expert’s understanding of risk and growth in their business. It’s never a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The value indicated in a personal financial statement should be viewed in the light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as national and local economy to explain the difference and changes in values over time. If an expert opines the value is X, but the personal financial statements says 3X or 1/3X, an expert must be prepared to explain the difference. Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data? The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries. As such, any sole comparison to general industry profitability data should be avoided. If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this could be problematic. RMA’s studies are organized by the North American Industry Classification System (NAICS). Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data may do the trick in certain industries, but most dealers sell both new and used vehicles. Further, RMA does not distinguish between different franchises. The National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data. However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships, and Mass Market Dealerships. While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available. Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than actual profitability of the business. The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000. At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified. For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101. What Is the Date of Valuation and Why Does It Matter? Depending on the state, family law matters might require the date of valuation to be the date of filing, the date of separation, the date of the trial (current), or some other date. Commercial litigation can require the date of valuation to be the date of a certain event, the date of trial (current), or some other date. Why does the date matter? In addition to the standard of value (generally fair market value or fair value), a business valuation contemplates a premise of value – often a going-concern business. The business appraiser must use the relevant known and knowable facts at the date of valuation to incorporate into a valuation conclusion. These facts reflected in historical financial performance, anticipated future operations, and industry/economic conditions can differ depending on the proper date of valuation.As we are all experiencing during COVID-19, the conditions of March/April 2020 are vastly different than year-end 2019. It would be incorrect, however, to consider the impact of COVID-19 for a valuation date prior to Spring 2020.How Have Auto Dealer Valuations Been Affected by COVID-19? Valuations of auto dealers involve many factors. We also try to avoid absolutes in valuation such as "always" and "never." The true answer to the question of how auto dealer valuations have been affected by COVID-19 is “It Depends.”As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a barometer. Depending on the day, the stock market has declined anywhere between 20-30% during that time from previous highs. Specific indicators of each auto dealer, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.The litigation environment is already rife with doom and gloom expectations and we’ve previously written about the phenomenon referred to as divorce recession in family law engagements. While some auto dealers may go out of business as a result of COVID-19, the valuation of most may be deflated from prior indications of value, but generally, the conclusion is not zero. As always, it depends on the specific facts and circumstances of each particular auto dealer under examination.Putting It All TogetherAs with all litigation engagements, the valuation of automobile dealerships can also be complex. A deep knowledge of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. Understanding how these components fit together is important to a successful resolution, just like the assembly and combination of pieces in a game of Tetris. If you have a valuation issue, feel free to contact us to discuss it in confidence.1 DCF methodology might have to be considered in the early stages of a Company’s lifecycle where the presence of historical financials either does not exist or are limited.Images by DevinCook via Wikimedia Commons

Revolution or Evolution: COVID-19 Pushing Auto Dealers into the 21st Century

While making a trip to the grocery this past week, I came across a billboard that caught my eye, but not for the right reasons. An advertisement had been recently removed, exposing a much older advertisement beneath. It was a 3-videos-for-$5 ad from Blockbuster. It provoked an instant sense of nostalgia as I remembered going with my family to pick out movies on Friday nights. Unfortunately, this old ad now serves as a cautionary tale of what can happen to businesses that aren’t able to keep up with ever-evolving consumer demands. Blockbuster had the chance to keep up by buying Netflix for $50 million in September of 2000, but the CEO thought it was a joke. Now with a market cap of $130 billion (as of May 1st), due to the influx of streaming demand, Netflix’s worth now surpasses Disney’s. The same cannot be said for Blockbuster, which shut down for good in 2014. Every industry faces the Blockbuster/Netflix dilemma at some point as they try to innovate to keep up with the changing times and stay relevant. The next big thing is always easier to see with the benefit of hindsight. The most recent of these changes has been in the retail space with the “retail apocalypse,” as brick-and-mortar stores are closing their doors as consumers opt for the ease of online purchases. Although initially evading the switch, the current COVID-19 pandemic has auto dealers scrambling to find ways to maintain sales as stay-at-home orders are keeping customers from the dealership. To move vehicles off the lot, dealerships have been pushed into a new era of online car sales. While many auto dealers have only somewhat dipped their toe into the digital space, they have now been pushed off the deep end. As Plato once said: "Necessity is the mother of invention." Early Modelers of Online Car SalesBefore the coronavirus outbreak, the two major players in online car sales were Carvana and Tesla. Though both engage with their customers primarily through electronic platforms, their business models differ. Founded in 2013, Carvana now boasts an inventory of over 29,950 used vehicles that can either be delivered to customers or picked up in one of their vending machines. Customers can even get approved for financing online. The company is now live in 146 markets and has doubled revenue in each quarter since its founding. Their ability to provide a larger selection of vehicles than traditional used car dealerships has helped it expand to the third-largest used-car retailer in the country. They also only sell used cars, which differentiates them from traditional dealers and may ultimately be more profitable. Gross profits for used vehicles are higher than for new vehicles. While Carvana operates as a virtual dealership for used cars, Tesla was founded in 2003 and operates as a manufacturer that eliminates the need for dealerships all together with its direct to consumer online sales strategy. Tesla has also experienced considerable revenue growth, and like Carvana, sports a lofty valuation compared to the traditional auto dealers.Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019.While not frequently employed in the valuation of auto dealerships, Tesla’s revenue multiple is 6.2x, compared to 0.5x or below for the five most traditional players. Carvana’s revenue multiple of 1.7x is also significantly higher despite negative earnings even before interest, taxes, depreciation, and amortization (EBITDA). While both of these companies likely command higher multiples due to their growth characteristics, their business models also appear to be weathering the coronavirus as Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019, while traditional auto dealers are down at least 25%.How Auto Dealers Are RespondingWhile these two companies used to be the outsiders, the pandemic has forced many auto dealers to follow in their footsteps. Fiat Chrysler launched a new online sales program this month that allows customers to go through the car buying process online. The purchased vehicle can be delivered to their home without a visit to the dealership, similar to the model Carvana and Tesla follow. Mark LaNeve, Ford Motor Co.’s U.S. Chief of Sales told Reuters that “around 93% of Ford’s 3,100 U.S. dealers are doing some or all aspects of sales online, from virtual tours to financing and home delivery, as the pandemic has shuttered showrooms in a growing number of states.” General Motors has increased efforts toward their online sales program, “Shop, Click, Drive,” that launched in 2013 but had not gained much traction. Other automakers such as Porsche have announced additional incentives for dealers to conduct digital sales as well.Looking Long-TermWith all the different measures being taken to bring car sales online, it is clear that dealerships are willing and able to provide this experience to their customers. However, there are significant costs in these changes, such as technology investment and retraining costs. Furthermore, while dealerships may be able to cut costs in the long-term by not having to utilize personnel to sell vehicles, this would have an adverse impact on employment. An example of this is Amazon’s effect on retailers with total retail employees declining by nearly 200,000 since 2017. The main concern and million-dollar question keeping auto dealers from fully investing in online business is this: Will consumers buy into an online model for the long-haul?Although a heavy investment into online technology may prove beneficial during this pandemic, if things return to “normal” and consumers revert to old buying preferences, dealerships might end up with large sunk costs.For many dealers, the switch to online vehicle shopping has been a long time coming.There are differing opinions regarding whether COVID-19 will lead to a long-term switch in consumer vehicle purchase preferences. For many dealers, the switch to online vehicle shopping has been a long time coming. With consumers being more tech-savvy than ever, e-commerce retail sales as a percent of total sales has grown steadily over the years, reaching 11.4% in Q4 2019. Rhett Ricart, CEO of Ricart Automotive in Columbus, Ohio, and chairman of the National Auto Dealer Association, believes that the coronavirus pandemic “is going to fundamentally change how people view buying a car.” Additionally, he predicts that “By the end of the year, you’re going to see 80%-90% of U.S. new car dealers with full e-commerce capability in their shop” to handle everything online except for the test drive and maybe the final signature. Online sales at his dealership have doubled since the pandemic started to ramp up. Certain data points support this assumption.Before the pandemic struck, 61% of car buyers say that the car buying experience was not better, and sometimes worse, than the last time they purchased a vehicle. A key area of frustration for buyers is how long it takes to purchase a vehicle from the paperwork to negotiation. The cross-selling many dealerships employ to increase profits can also grate on some consumers who don’t want to be upsold. With digital retailing allowing dealerships to reduce the time it takes to buy a car, this could end up alleviating a consumer pain point.While some dealers are more bullish on their predictions for the online vehicle sales market, others remain skeptical. David Smith, CEO of Sonic Automotive, has noted that although consumers can conduct a majority of the sales process online, he has doubts over whether this sales model will be long lasting. “It is such a large purchase for most people,” he said. “It’s not like going to the grocery store. It’s a big deal. It’s a big purchase. People like to see it and browse.” He might be onto something, with 79% of buyers waiting but still willing to buy, there are a whole lot of potential car buyers holding out even though many dealers have gone online. And with the average monthly car payment for a new car being around $550, it’s reasonable that a customer wants to see the car in person before they make such a big commitment. Furthermore, considering that Carvana has yet to turn a profit, and Tesla has only achieved a narrow profitability in the past year, there are still many uncertainties on the success of online vehicle sales.ConclusionUltimately, the jury is still out on whether we are witnessing a revolution in the auto industry such as we saw with Blockbuster and online streaming, or simply an evolution into more tech-savvy dealerships. While we doubt the pandemic will be enough to radically push the entire process online for all consumers, we do believe certain benefits of digital are here to stay.Most auto dealers are trying to find ways to offer customers vehicles in any way they can. The adoption of e-commerce tools for dealerships, even in the short-run, can help to show consumers that dealerships are willing to go the extra mile in order for them to be comfortable making a purchase during this difficult time.After beginning with a Plato quote, I thought it would be fitting to end with one as well: "There are two things a person should never be angry at, what they can help, and what they cannot." In the midst of this unprecedented global pandemic, I find it to be a timely reminder.

A Deeper Dive into the Impact of COVID-19 on Auto Dealerships

Auto dealers are in a unique situation. While technically categorized as consumer “discretionary” items, many people rely on their cars to navigate their busy daily lives. With activity grinding to a halt amidst stay-at-home orders, cars are tipping more towards discretionary items (despite many dealerships being deemed essential businesses).While more practical than other expensive purchases, like a designer handbag, automobiles become less of a priority when budgets are trimmed, particularly when people are staying at home. All told, this will likely lead consumers to delay their purchases of cars, particularly those who want to peruse their options by walking a lot and test driving various makes and models.While other retail industries have fallen prey to the “Amazon effect,” auto dealers have avoided this fate because many consumers are not yet comfortable making such a significant investment without first getting behind the wheel. However, this means sales activity is even more adversely impacted by the current environment. Consumers with disposable income are more likely to spend it on other high-end items that require less personal inspection for style and feel before buying. As we’ll discuss, this is just one of the impacts the coronavirus is having on the auto industry.How Long Will COVID-19 Last?The key questions for auto dealers, and all other business owners, are how long this period will last and how COVID-19 will impact consumer spending on the other side.While lack of wear and tear will delay many timelines, people will still need cars.Buying a car is a significant investment that many consumers will simply delay as staying inside doesn’t require much car travel. In fact, some auto insurers will issue rebates as they expect claims to decline during this period.While lack of wear and tear will delay many timelines, people will still need cars. Significant mileage or a wreck are the most obvious reasons someone would require a new car, but not all purchases are necessitated by the status of a prior vehicle. Getting married, having a child, or turning 16 are life milestones that tend to increase car sales, and these are not necessarily going to be halted by the pandemic. However, if the economic reverberations cause consumers to forego rather than simply delay their automobile purchase as budgets are slashed on the backside of this, a permanent loss in demand would likely prove extremely detrimental to auto dealers.How Will the Auto Industry Respond to COVID-19?While the proliferation of the Internet may not have fully infiltrated the auto dealer business model before the pandemic, the impact of the coronavirus on the way people shop has likely forced dealers to reconsider their digital strategy. Tech-savvy consumers were already using services like TrueCar and Kelley Blue Book to increase price transparency and lower gross margins. While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.Aside from ramping up web presence, dealers must also consider how they will collectively respond to the reduced demand.Contrast auto to another significantly impacted industry: restaurants. Restaurants can significantly decrease prices in order to keep customers coming through their doors. While they are sacrificing some profits by offering it cheaper, restaurants have plenty of turnover, and customers tend to return to their favorite places frequently. Auto dealers operate differently. Given the relatively long vehicle shelf life, dealers do not frequently experience near-term repeat customers (except for service and maintenance operations).Dealers can get creative with their inventory to get cash infusions, though many will opt to offer increased incentives to boost sales. However, front-loading sales with incentives to make it through the tough times could have negative impacts on industry volumes as well as profits down the road. This pain will be particularly acute if some shoppers accelerate their purchases to take advantage of falling prices when they otherwise may have tried to delay a big expenditure by servicing their aging vehicle instead.Incentive spending hit an all-time peak at $4,800 per vehicle in March, which supported the SAAR (a seasonally adjusted measure of Light-Weight Vehicle Sales) from dropping even further than it did. While annual sales have been above 17 million since 2014, this has included significant increases in incentives which come at the detriment of profitability. Gross profit is a much more relevant metric than revenue in the auto dealer industry, and revenues and volumes propped up by incentives that do not translate to improved gross profits will ultimately hurt dealership valuations as earnings deteriorate.Government ResponseGovernment response to this pandemic has come through both fiscal and monetary policy. Congress’ efforts on the fiscal side have been more visible, culminating with President Trump signing a $2.2 trillion economic package (the “CARES” Act) into law on March 27. Stimulus checks have started to roll in and the small business loan program, Paycheck Protection Program or “PPP”, has already reached its $349 billion limit. On Thursday, April 24th, Congress passed an additional $484 billion economic package with $320 billion replenishing the PPP, $60 billion in additional SBA disaster relief funds, and $100 billion to support hospitals and increased testing.Government Response Impact on DealershipsMany auto dealers, even those with significant top-line revenues, will qualify for small business grants and forgivable loans. For those on the fence about maintaining their workforce due to sharp decreases in demand for their services, these programs are structured to incentivize dealers to retain their staff.The PPP is likely to boost morale for dealers able to retain their full staff during this time; this also saves future costs of having to train new staff when activity ramps back up. Still, tough decisions will have to be made, and auto dealers may be forced to cut costs they hadn’t considered during the long bull market that categorized the past decade.The auto industry isn’t likely to receive the extensive aid being provided to airlines, but the small business loans won’t be the only impact the CARES Act has on dealerships. The $1,200 payments to consumers are unlikely to motivate people to go out and buy a car, but it could provide enough money to make car payments and get tune-ups or other necessary maintenance.ConclusionAt this point, there are likely more questions than answers. The first order and second order effects of the virus are being measured in real time, and we likely won’t be able to fully understand its impacts until we have the benefit of hindsight. Government responses are likely to continue, though it is unclear the form of future actions.What we do know is that many consumers are staying indoors, and odometers have slowed. Dealers must do what they can to maximize this downtime by increasing their digital presence and managing expenses and working capital. While dealers may need to sell at lower prices, they will have to balance near-term needs with long-term impacts. We have been impressed by the outpouring of support dealers have shown for their communities. We encourage everyone to continue checking in with family, friends, employees, customers, suppliers, and our local communities.

March 2020 SAAR

When Might Things Return to Normal?

The term “24-hour news cycle” doesn’t do justice to the rate at which new information becomes available and is consumed by people trying to understand the significant impact COVID-19 is having on all of us. Stay-at-home orders have created a huge demand shock, which is particularly harmful to a largely service-based economy. In this post, we contextualize some of the fallout that has been experienced and try to answer the question “when will things return to normal?”.March SAARSAAR came in at 11.372 million, the lowest level since April 2010.As expected, SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined considerably in March as the early effects of COVID-19 began to impact just about every industry across the globe. SAAR came in at 11.372 million, the lowest level since April 2010. This also represented a decline of 32.4% from February. The 32.4% decline was only the fourth time since 1976 (when the SAAR was first recorded) that a 30% month-over-month decline has occurred. The first two instances were during a 6-month period of extreme volatility between September 1986 and February 1987, including three monthly increases of over 22% and two declines of 31.6%. Despite these anomalies, the only other significant month-over-month decline occurred in September 2009 when SAAR declined 35.8%. However, SAAR had increased by 14.2% and 28.1% in the two preceding months, so that September’s steep decline was only 6.1% below the preceding June.While the huge drop in volumes in March was certainly historic, it included a couple of weeks that were relatively unscathed by stay-at-home orders. April is likely to show further declines with significant uncertainty about when we will reach the bottom.Putting it in PerspectiveWhile there have been many sharp one-month declines in the SAAR, we note that even seasonally adjusting the data can fail to capture certain calendar anomalies, specifically when one month has an extra selling weekend. In looking at other significant events, such as the stock market crash in ’87 and 9/11, the drop caused by the market crash was relatively short-lived and auto volumes actually spiked in the month following 9/11 as the country braced for war. To better understand where we might be headed and when things might return to some level of “normal,” we analyzed prolonged declines, focusing on the 1981-1982 recession, the Persian Gulf War, and the Great Recession. Though these events do not align perfectly with COVID-19, observing how periods of economic turmoil affect the industry and examining the length of recovery time historically can provide future insight as we seek to climb out of the current crisis.There are numerous ways to measure recovery. For purposes of this post, we measure “recovery” as how long it takes to return to a “steady state” of vehicle sales. We use a steady state figure of 15.6 million annual sales from a 2015 paper written by Austan D. Goolsbee (University of Chicago) and Alan B. Krueger (Princeton University). The paper analyzed the restructuring of General Motors and Chrysler. The inputs into the regression model used in the paper include:Real GDP GrowthThe unemployment ratePopulation growthThe Federal Reserve’s Senior Loan Officers’ Survey (SLOOS) measuring willingness to lend to consumersLog of average real price of a gallon of gasoline (for the preceding quarter)Standard deviation of gas prices over the preceding four quarters In every year since the paper was published, industry sales have surpassed 17 million, indicating the steady state may be biased upwards if rerun today. However, the data stops in 2007 just before the Great Recession, and because auto sales are procyclical, any increase in the steady state figure would likely be due in part to the longest economic expansion in the country’s history over the past 11 years. Further, since vehicle sales are positively correlated with population growth, we would expect a long-term figure to be higher than early years and lower than more recent years. Ultimately, we find a steady state figure of 15.6 million to be reasonable for this analysis. A Long Term View of SAAR A long-term view of SAAR is presented in the graph below: [caption id="attachment_30880" align="alignnone" width="940"]Source: FRED and Princeton University[/caption] The 1981 RecessionAt the time, the 1981 recession was the worst economic downturn in the U.S. since the Great Depression. Triggered by a combination of monetary and global energy issues, unemployment reached 11%. While the effects of the recession were widespread, the manufacturing, construction, and auto industries were particularly affected. Auto manufacturers ended 1982 with 24% unemployment. The industry saw 4 straight years of year-over-year declines in sales from 1979 to 1982 with the largest annual decline in 1980 at 19%. SAAR bottomed out in October 1981 with only 9,209,000 annualized vehicle sales; from there, SAAR increased 17% in both 1983 and 1984. SAAR reached over 15.6 million sales in August 1985, approximately 7 years after it first dropped below this threshold in September 1978.As noted previously, population growth likely indicates the 15.6 million is a high threshold for this period, particularly since SAAR was only above this for a brief period in 1978. The precipitous decline at the beginning of 1980 appears to have been restored by the end of 1983, indicating just 4 years before recovery.The Persian Gulf WarThe Persian Gulf War, precipitated by Iraq’s invasion of Kuwait, caused the oil shock of 1990. Though less severe than oil shocks that occurred in the 1970s, oil prices initially soared from a pre-invasion price of around $18 a barrel to above $40 in the late fall of 1990, leading to declining revenues for the auto industry. At the same time, the Fed was tight on interest rates, endangering an already weak economy. This combination of oil prices and economic policy brought the U.S. into a recession that hit the auto industry particularly hard. Vehicle sales declined each year from 1989 through 1991, with the biggest decrease in 1991 at 11%. It took until April 1994 for SAAR to reach 15.6 million again, about 4 years after it first began to drop.The Great RecessionArguably the most impactful event on the industry in recent history was the Great Recession (2007-2009). Precipitated by a financial crisis caused by a severe contraction of liquidity in global markets, businesses were forced to reduce their expenses and investments and layoffs resulted. From December 2007 to June 2009, real GDP declined by 4.3% and unemployment increased from 5% to 9.5%, peaking at 10% in October 2009.The auto industry and other industries reliant on consumer loans (e.g., housing) suffered significant losses. In 2006 and 2007, vehicle sales volumes decreased about 2.5% consecutively, and the auto industry hourly workforce was reduced from over 90,000 to approximately 40,000. Conditions worsened through 2008 and 2009, as sales declined 18% and 21%, which is the largest year-over-year decrease of any time period. SAAR dropped to just a little over 9 million in February 2009, 6.6 million below the steady state SAAR. However, through the assistance of the government in the Troubled Asset Relief Program (TARP) and the end of the recession in 2009, the industry survived and returned to its steady state of 15.6 million vehicle sales in 2013, 5 years after it first dropped below that level in January 2008.COVID-19There are some positive takeaways from looking at these past events.Although economic conditions currently point to a difficult period of uncertain length, there are some positive takeaways from looking at these past events. Periods of high growth have followed periods of low sales as consumers who delayed purchases in rough times returned to the market. SAAR increased 17% consecutively in both 1983-1984, following the 1981 recession. There were increases of 8% in both 1993 and 1994 following the Persian Gulf War. Finally, the auto industry experienced 5 years of expansion following the Great Recession, reaching similar sales as before the crisis and further set new highs in the 5 years after that.Again, it may take a while to return to the 17 million in sales seen in the past few years, but that is above the long-term average and should not necessarily be the level from which we measure recovery. NADA expects it could take three or more years to return to this level, which would be reasonable given historical recovery times.ConclusionThe auto dealer industry is resilient through tough times. We hope dealers are once again able to navigate both the known and unknown problems facing us today. Dealers must grapple with how to continue to pay their employees, alter their sales channels on the fly, and potentially even help teach their children at home.Mercer Capital stands ready to partner with dealers in their time of need. Prior to the nationwide lockdowns, we were anxiously awaiting the NADC Conference in Florida at the end of April as well as the TAA/KYADA Conferences in June. We had hoped to launch this blog in happier times, but we still plan to offer our unique perspective as valuation experts as the pandemic impact unfolds. Working from home, we have more time to write these blogs, and we hope they are interesting to you. Feel free to reach out to us if you have valuation questions as to how your dealership may be affected.Mercer Capital is a financial services firm specializing in business valuation. We also provide litigation support and transaction advisory services for clients big and small. Contact one of our professionals to discuss your needs in confidence. And stay safe.

Looking Back to Look Forward

Lessons for the Auto Dealer Industry

My colleague, Travis Harms, published an article on his Family Business Director Blog entitled “Looking Back to Look Forward” earlier this month making observations from companies that survived the Great Recession. Travis analyzed data from 554 operating companies for two-year periods before the Great Recession (2006 and 2007), two years during the Great Recession (2008 and 2009) and two years following the Great Recession (2010 and 2011). Travis concluded five observations from the data analyzed:Operating leverage can be managedWorking capital really is a source of cash during a downturnCompanies become more disciplined investorsBorrowers reduce debt levelsDividends are much less affected than share buybacks The pool of selected companies included operating businesses thus excluding financial institutions and real estate companies that were more adversely impacted by the Great Recession. While the search didn’t specifically include auto dealers, several of the observations/lessons can be applied directly to the specific operations and challenges that auto dealers are facing in today’s COVID-19 economic climate. We focus on the first three of these observations as they related more directly to auto dealers.Operating Leverage Can be ManagedThe data from Travis’ study illustrated that the companies experienced a 15.6% revenue decline in 2009, but EBITDA margin only fell slightly by 0.5%. How was that possible? Companies were able to mitigate the decline in revenue from falling to the bottom line by making conscious efforts to reduce expenses. The Auto Dealer revenue model consists of new vehicle sales, used vehicle sales, parts and service, and finance and insurance. As we’ve written about and discussed in this space, new vehicle sales as illustrated by SAAR, have fluctuated with the economic cycle. In times of declining new vehicle sales, successful dealerships have shifted focus to their other profit sources. Additionally, dealerships have focused internally on managing and reducing internal operating costs. In 2019, light vehicle sales in declined in the US, and industry executives were highlighting other aspects of their business model mitigating declining volumes as indicated by SAAR before the spread of the virus. Dealerships already had an eye on monitoring costs from sluggish performance times in the past, and managers can lean on their experience from the Great Recession in terms of finding which costs can be cut.Working Capital Really is a Source of Cash During a Downturn The companies in Travis’ sample reduced working capital by $20.8 billion to mitigate lost revenues of $175 billion. Those in the auto dealer industry know that working capital is dictated and monitored by the manufacturer with requirements usually listed on the front page of the dealer financial statement. If auto dealers aren’t afforded the luxury of reducing their working capital, how can it become a source of cash during a downturn? Throughout the last month, one of the mantras that I’ve heard repeatedly in the auto dealer space is that dealers need to maximize any source of revenue or equity at the dealership. One such place is the inventory – auto dealers should become acutely aware of the economics of every unit on their lot. Most auto dealers obtain floor plan financing for all of their new vehicles and at least a portion of their used vehicles. However, not all auto dealers finance their used vehicles or the entire portion that their lender will allow. During these economic times, auto dealers should consider contacting their lenders to discuss the financing terms on their used vehicles that have yet to be financed. For example, if a dealer currently finances 50% of the value of their used vehicles, but the lender will allow 80%, why not finance the additional 30% to create cash flow?When auto dealers are scouring their lot for used vehicles that aren’t being financed, another strategy they should consider is expediting the sale of aging used vehicles that are not selling in the retail market. Opting to move these vehicles through the wholesale or auction market can turn idle inventory into cash flow, which is key for auto dealers in the coming months.Companies Become More Disciplined Investors The figures from Travis’ study concluded that total investment spending from the companies in the sample declined nearly 80% during the analyzed period. Auto dealers have image and real estate upgrade requirements from the manufacturers. As we’ve previously covered in this space, the quality/condition of real estate is one of the key value drivers in the valuation of a particular store. Successful dealerships have already been maintaining their real estate and image requirements, so they should hopefully be able to minimize their capital expenditures over the remainder of 2020. Manufacturers are also likely to be less forceful in compelling dealers to upgrade their facilities until the economic environment improves. Adding different brands/rooftops is another way an auto dealer can add value, giving consumers more options and spreading overhead costs over more sales. Dealers are less likely to make these investments during economic uncertainty, though it may also entice some local competitors to seek to exit the business, which could provide an opportunity given a mutually beneficial circumstance.ConclusionsAuto dealers are a resilient, adaptable group by nature. It’s one of the reasons many have been able to survive economic hardships or sluggish industry conditions in the past. While we haven’t witnessed the unique totality of the conditions that are present today, auto dealers can adopt some of the principles from the Great Recession to try and mitigate the challenges during the survival mode portion that we currently face.

Auto Dealership Valuation 101

Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals. Valuations of automobile dealerships are unique even from the valuation of manufacturing, service and retail companies. Automobile dealership valuations involve the understanding of industry terminology, factory financial statements, and hybrid valuation approaches. For these reasons, it’s important to hire a business valuation expert that specializes in automobile dealership valuation and not just a generalist business valuation appraiser.TerminologyUnlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes and Depreciation (“EBITDA”) are virtually meaningless in automobile dealership valuations. Instead, this industry communicates value in terms of Blue Sky value and Blue Sky multiples. What is Blue Sky value? Any intangible/goodwill value of the automobile dealership over/above the tangible book value of the hard assets is referred to as Blue Sky value. Typically, Blue Sky value is measured as a multiple of pre-tax earnings, referred to as a Blue Sky multiple. Blue Sky multiples vary by franchise/brand and fluctuate year-to-year.Another unique aspect of automobile dealership valuations is the reported financial statements. Unlike valuations in other industries where the preferred form of financial statements might be audited/compiled or reviewed financial statements, most reputable valuations of automobile dealerships rely upon the financial statements that each dealer reports to the franchise/factory, referred to as Dealer Financial Statements. Why are Dealer Financial statements preferred? Dealer Financial statements provide much more detailed information pertaining directly to the operations of the dealership than any audited financial statement. Valuable information includes the specific operations and profitability of the various departments including, new vehicle, used vehicle, parts and service, and finance and insurance. Each department is unique and has a different impact on the overall success and profitability of the entire dealership. Automobile dealerships are required to report these financial statements to the factory on a monthly basis. However, an experienced business valuation expert knows to request the 13th month dealer financial statements. If a year only has twelve months, then what are the 13th month dealer financial statements? The 13th month dealer financials typically include the year-end tax adjustments such as adjusting the value of new/used vehicles to fair market value by reflecting current depreciation and other adjustments.Valuation Approaches Asset-Based ApproachThe asset-based approach is a general way of determining a value indication of a business or a business ownership interest using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to adjust the various tangible and intangible assets of an enterprise to fair market value. In automobile dealership valuations, the asset method is utilized to establish the fair market value of the tangible assets. This value is then combined with a Blue Sky “market” approach to conclude the total fair market value of the automobile dealership.Income ApproachThe income approach is a general way of determining a value indication of a business or business ownership interest using one or more methods that convert anticipated economic benefits into a single present amount.The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.How is the income approach unique to the automobile dealership industry? First, projections are rarely produced or tracked by automobile dealers, so historical capitalization methods are mostly used. Second, most automobile dealerships are dependent on the national economy, and sometimes to a larger degree, their local economies. What impact does this have on the income approach? Business valuation appraisers need to analyze and understand the dependence of each automobile dealership to the national and local economy which usually affects the seasonality/cyclicality of operations and profitability. Once again the automobile dealership is unique in that it can experience seasonal/cyclical fluctuation in a given year, or more importantly, it fluctuates over a longer period of more like five to seven years.Market Approach The market approach is a general way of determining the value indication of a business or business ownership interest by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.In the automobile dealership industry, traditional market approaches are basically meaningless. While there are a few publicly traded companies in the industry, they are large consolidators and own numerous dealership locations of many franchises in many geographic areas. Private transactions exist, but generally not in a large enough sample size of the particular franchise of the subject interest to provide meaningful comparisons.So how does a business valuation expert utilize the market approach in the valuation of automobile dealerships? The answer is a hybrid method utilizing published Blue Sky multiples from transactions of various franchise dealership locations. Two primary national sources, Haig Partners and Kerrigan Advisors, publish Blue Sky multiples quarterly by franchise. As discussed earlier, these multiples are applied to pre-tax earnings and indicate the Blue Sky or intangible value of the dealership. When combined with the tangible value of the hard assets determined under the Asset Approach, an experienced business valuation expert is able to conclude a total value for the dealership using this hybrid approach and communicate that result as a multiple of Blue Sky that will be understood and accepted in this industry.ConclusionsThe valuation of automobile dealerships can be more complex than other valuations due to their unique financial statements, varying cost structures and profitability of departments, different terminology, and hybrid valuation methods. Hiring a business valuation expert that specializes in this industry rather than a generalist business valuation appraiser can make all the difference in providing a reasonable valuation conclusion.

February 2020 SAAR

SAAR came in at 16.833 million for February 2020, down about 0.5% from January’s revised figure, but up 1.9% from February 2019. However, part of this gain is attributable to calendar quirks as not only was 2020 a leap year, but this extra day fell on a Saturday, providing the first February since 1992 with five selling weekends. Through February, 2.49 million light vehicles have been sold in 2020, up 4.5% from last year. This increase comes entirely from light trucks, as year-to-date volumes have increased 11% for this segment while autos have declined 11% over the same period. Trucks have made up 74% of light vehicle sales so far in 2020, up from 70% last year and continuing a trend since 2012 when trucks were just under 50%.As seen above, SAAR has been below 17 million in eight of the past twelve months with an average of 16.938 million. Solid performance in the first two traditionally slow months of the year puts 17 million units within reach for the year, though expectations in the range of 16.5 million to 16.8 million certainly seem plausible. February’s performance may not be duplicated in March due to uncertainty surrounding the impact of COVID-19, commonly known as the Corona Virus.On the supply side, the key question will be how the virus impacts automotive manufacturers and their abilities to source products. Shutdown of Chinese plants has caused manufacturers to find alternative means, which can add to costs. If problems linger, the ramifications would likely decrease volumes globally, as Goldman Sachs recently downgraded its outlook on 2020 global auto sales to a 3.5% decline from 2019 per the Wall Street Journal. Vehicle sales in China were down a whopping 80% in February compared to the prior year. Similar effects were felt in countries where the disease has begun to spread with South Korea, Japan, and Italy, down 20%, 10.7%, and 8.8%, respectively. While the impact on the U.S. has thus far been much lower than these countries, sales volumes are likely to be adversely affected. While the mortality rate is estimated at or below 1%, the economic fallout has already proved to be significant due to the uncertainty and panic.As for demand, there is little data available to determine the preliminary affects of the virus. However, should foot traffic decline with consumers limiting their social exposure, sales would likely decrease as internet sales have increased but the online experience remains far from substituting the experience of test drives. As discussed above, selling weekends are particularly important to the industry, which are in jeopardy if consumers opt to stay at home.On March 3, the Fed opted to cut rates 50 basis points to support the economy while citing domestic economic strength. This rare inter-meeting rate cut was the first such cut since October 2008, but this did little to ease markets as the S&P 500 still finished the day down 3%. According to interest rate futures, an additional 25 basis point cut is nearly certain at the meeting on March 19-20 with a greater than 50% chance this cut is 50bps.Lowering interest rates seeks to induce economic activity, and specific to the automotive sector, this cut in part seeks to induce consumers into purchasing vehicles. While discounts may make people buy more on their weekly trip to the grocery store, a relatively small reprieve in ongoing interest payments is unlikely to change the decision of whether to make such a significant purchase as a car for most consumers. Lower funding costs also seek to encourage business expansion, though dealerships’ position in the supply chain (last stop before consumer) limits the impact rate cuts will have on their decision making. Dealers rely on their manufacturers for inventory, who in turn rely on the companies building these parts which means dealers’ supply will feel second-order impacts with minimal ability to navigate these changing market dynamics. However, lower interest rates should reduce floor-plan costs, which represents a nice benefit. If volumes are adversely affected, floor-plan costs will drop even further with less inventory on the lot. But as business owners are acutely aware, not all operating expenses are tethered to activity, and prolonged sluggish activity would weigh on dealerships, like many other businesses, particularly those with significant debt burdens. Like everyone else, we will continue to monitor the situation.The global uncertainty and equity market volatility resulting from COVID-19 may present investors with an opportunity to buy at a depressed valuation. Similarly, auto dealer owners who are bullish on the long-term investment merits of their business may see this as an opportunity to transfer their interests to future generations in a tax-efficient manner. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.

What Does Tesla’s Share Price Soaring Mean for My Auto Dealership?

Tesla, the custom luxury and electric vehicle company, has seen significant fluctuations in its share price in the past few months. On October 24th, the Company announced its first quarterly profit (of $143 million) after losing over $1 billion in the first two quarters. It followed this up with $386 million profit in Q4, including a jump in gross margin from 4.1% to 18.8%. If the company can sustain profitability over four quarters (including profitability in Q2 2020), Tesla will meet the minimum criteria to join the S&P 500 Index. It is approximately the 50th largest company in the US (as of March 6, 2020), and after its recent runup and automotive-adjacent Uber Technologies languishing, Tesla is currently by far the largest US company not included in the large-cap index. Should the company’s profitability remain, its share price may elevate even further as investors buy in advance of its addition to the index, a strategy called “index front running.”While Tesla may or may not qualify later in the year, this isn’t the only trading quirk to exogenously impact the company. Share price skyrocketed to $887 at close on February 4th (up 56% in a week and 180% in three months) due in part to a short squeeze where traders faced margin calls and were forced to close their positions at a loss. There are about 18.4 million shares sold short, or about 12.6% of its float (shares outstanding excluding those held by insiders). While Tesla has accumulated a cult following of people both for and against, its share price likely has little to do with the value of franchised dealerships in the US.How is Tesla Different?Tesla has significant differences from dealerships with established brands across the spectrum such as BMW, Toyota, and Ford. These dealerships buy inventory through their auto manufacturers, whereas Tesla uses a direct sales strategy. The dealer franchise strategy has allowed for a large geographic footprint for other manufacturers whereas Tesla has been less able to mass produce. While less ubiquitous, the Tesla brand has benefited from its exclusivity. Further, its direct sales strategy has eliminated any conflict of interest between manufacturer and dealer. One example of this friction is when manufacturers overproduce and push inventory onto the lots of dealers, increasing floor-plan interest costs and oversupply can limit pricing growth.Tesla’s cars are also unique beyond the initial sale. Unlike other cars, Tesla’s cars cannot be fixed by third-party service providers as easily. Whereas a consumer may opt to go a local body shop for their Ford truck, a Tesla owner is more likely to go to a Tesla related service department, which tends to be a higher margin business for dealers. This represents an opportunity for Tesla, provided it can properly address the service needs particularly as its manufacturing operations continue to scale. While not typically viewed as maintenance, Tesla’s power source is also unique. For electric vehicles, consumers can charge their cars at home or at Supercharger stations instead of gas stations. While electric vehicles are viewed as cheaper and more eco-friendly, adoption of EVs relies on an increasing network effect where charging options approach the abundance and accessibility as gas stations.Future of Electric Vehicles (EV)Tesla did not invent the electric vehicle, nor will it appeal to all consumers as electric vehicles have range limitations particularly on road trips. There are also large upfront costs both for the vehicle and in-home charging stations. Further, numerous brands also offer electric vehicles including Kia, Hyundai, Chevy, Nissan, VW, Audi, Jaguar, and BMW, the latter of which just recently released it's latest and greatest. While the EV market is expected to increase over time, Tesla will clearly not be the only benefactor despite its ability to garner headlines, due in part to their enigmatic founder, Elon Musk. The company’s share price may represent a long-term bet on this power source, though Tesla is not likely to harvest all of the benefits. Still, dealerships and more importantly their manufacturers will do well to keep up with shifting consumer preferences including both EVs and the increasingly prevalent SUVs (particularly the cross-over segment).If Not Tesla, Where Do I Look for Valuation Insights for My Dealership?For dealer principals looking to keep up with the current trends, monthly releases of SAAR give an indication of volumes in the US that is frequently quoted as a barometer for the market. However, this does not factor in a variety of considerations including the level of incentives to induce these purchases. Further it tells little to nothing about a dealership’s service department, where a significant portion of gross profit is made. Public auto dealers, such as Auto Nation and Asbury Auto Group, indicate how investors in public equities view dealerships. However, these are limited comparisons for dealerships that are more geographically concentrated, may carry fewer brands, and have limited access to capital markets. Looking at stock prices and valuations like Tesla or other manufacturers such as Ford and GM may give a look into the overall health of the auto sector but will be even more limited for dealers.Transactions tend to be a reliable indication of value as it shows what someone was willing to pay for a dealership, not just a small, non-controlling fraction of it. Resources such as Haig Partners and Kerrigan Advisors publish quarterly indications of Blue Sky (value of a dealership in excess of net asset value, expressed as a multiple of pre-tax earnings) which cull transaction data. While frequently quoted in the industry, it is unlikely that buyers would simply apply such a blue sky multiple without rigorous due diligence to understand the idiosyncratic aspects of cash flow, risk, and growth, inherent in a target dealership.At Mercer Capital, we provide a variety of services for owners of car dealerships and dealer principals. We analyze 13th month dealer financial statements, evaluate facilities (including rent factors, lots, and service bays) and develop independent and reliable valuation appraisals and calculations for a variety of needs and circumstances including buy-sell agreements, litigation, and more. For an understanding in how your dealership is performing along with an indication of what your dealership may be worth, contact a professional at Mercer Capital to discuss your needs in confidence.

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Nicholas J. Heinz

Managing Director

David W. R. Harkins

Vice President

Isabelle L. Freireich

Financial Analyst

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Auto Dealership Industry

The auto dealership sector includes franchised and independent dealers engaged in the sale and service of new and used vehicles. Mercer Capital provides auto dealerships with independent valuation, transaction advisory, litigation support, and related advisory services.

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