As the year comes to a close, 2012’s buy/sell activity surprised me. I had expected a large number of dealerships to trade hands this year, particularly given the aging demographic of the dealer community and the rise in blue sky values. Instead, fewer transactions closed, particularly large transactions.
By way of example, at the 2012 National Association of Minority Automobile Dealers (NAMAD) Conference, the Ford representative commented that less than 2% of Ford’s franchises were expected to trade hands in 2012. At that rate, it would take 50 years for the current generation of Ford dealers to sell their franchises to the next generation. This is quite remarkable given Ford’s current financial strength and the commensurate increase in its dealerships’ values.
I believe the 2012 decline in buy/sell activity was driven primarily by price. Buyers and sellers simply did not see eye to eye. Sellers were enjoying record profits and expected premium prices to sell, while buyers still demanded a minimum 15% return on their acquisition investment and were unwilling to reach for blue sky. The result: deals did not get done.
As a reminder, a dealership is only worth what a buyer can and will pay and what a seller can and will accept at any given point in time. Both buyer and seller need to agree on price for an exchange to occur. If no exchange takes place, no one knows where value lies.
Reflecting on 2012, clearly many buyers believed sellers’ pricing expectations were irrational. But were they? Given today’s low yield investment environment, maybe sellers were incredibly rational.
Many sellers asked themselves, if I sell my dealership today, where can I invest my sales proceeds and what will those investments earn? They compared their current dealership cash flow to what they could earn on their capital in the market. The difference was so extreme to the negative that many sellers decided a sale was simply not in their best interest. Only for a premium price would a seller agree to part with his dealership cash flow. This line of thinking was in fact quite rational.
Today, Presidio estimates the average return on investment for a dealership acquisition is between 12.5% and 25% (see Chart 1). This estimate, based on Presidio’s most recently published blue sky multiples, assumes no leverage and excludes real estate. With leverage (which is increasingly available at attractive terms), dealership acquisition returns could jump to more than 40%.
I should note that the return estimates in Chart 1 assume the buyer sees no growth in dealership cash flow after the acquisition. If a buyer increases dealership profitability post-acquisition (a relatively conservative assumption), the rate of return on these investments significantly increases.
In stark contrast to expected dealership acquisition returns, the rates of return available in today’s investment marketplace are very low (see Chart 2). A dealership acquisition looks particularly attractive when you considering the risk removed from the auto retail industry as a result of the credit markets’ recovery, manufacturers’ improved financial health, and dealerships’ increased profitability. And yet, buyers often scoff at current multiples and are unwilling to reach for a higher blue sky number, even if the expected return on an acquisition far surpasses any alternative investment.
Many dealership buyers want a minimum 15% return on their capital investment, sometimes even higher. One might consider this an irrationally high return expectation in the current market. I believe these return expectations are a vestige of the past – of a time when the Fed Funds Rate was 5%, not zero, and when there were in fact attractive alternative investment opportunities that produced a 15% return without a high level of risk. That’s not today. For buyers to convince sellers to part with their relatively safe dealership cash flow, buyers are going to have to increase prices and likely reduce return expectations.
In my article, “You’re not a floor plan lender, you’re a car dealer” June 2012 issue of Dealer magazine, I note that many dealers reinvest their excess cash flow into their vehicle inventory by paying down floor plan. Dealers often make this investment decision because they are more comfortable investing in themselves than in the capital markets. The question dealers should ask themselves is: If I am willing to floor my own inventory for a 2% return, shouldn’t I be willing to buy another dealership for an 8% return, a 400% improvement over my floor plan return? I think the answer is yes, particularly when you take into account that both investments are exposed to the same economic risk factors– it’s just that one pays you for that risk.
Buyers, it’s time to recalibrate your return expectations for dealership acquisitions. When the next acquisition opportunity comes along, consider your investment alternatives. You won’t likely find a higher returning investment than a dealership, particularly on a risk adjusted basis. So sharpen your pencil and be rational with your pricing. I can assure you the seller will be.