Buy/sell activity in the first half of 2014 rose 75%, with private acquirers once again leading the industry. The strength of auto retail sales, particularly in the luxury segment, continues to support strong buy/sell activity and high blue sky prices. Below are the four notable trends I saw in the second quarter.
1. High Demand Markets Create Big Blue Sky Premiums:
Buyers are willing to pay steep premiums to acquire franchises in certain high demand markets. States with the highest sales per dealership are often in the greatest demand (see Chart 1). Arizona, California, Florida, Texas, Colorado, and Nevada are amongst the most sought after markets, according to our database. By contrast, the Midwestern states are the least sought after markets, due to slower population growth and sales seasonality.
For certain franchises, location can have a meaningful impact on franchise value. Domestic blue sky values are most affected by location and market, as Chart 2 demonstrates. For example, domestic franchises in high demand markets can achieve the same blue sky values as Honda or Toyota franchises in the same market.
2. An Increase in Large Transactions is Expected in the Near Term, Questionable in the Long Term:
In addition to the increase in the number of multi-dealership acquisitions (Chart 3) and the announcement of the Lithia/DCH transaction, I’m aware of a number of sizable acquisitions which are in process and likely to be announced in the second half of 2014. Many large private groups, public companies, and private equity firms are eager to buy sizable groups. More of these groups are becoming available due to the ageing of the dealer body and today’s high blue sky values.
I’m concerned that after several of these larger transactions are completed, the select number of buyers who can complete large deals will need to digest their acquisitions and will slow their spending, limiting the exit options for other large groups. Our industry has a structural imbalance which naturally results in more sellers than buyers. Manufacturer imposed barriers to entry and framework agreements limit the number of approvable buyers. Roger Penske made clear on his company’s second quarter earnings call that he would not likely acquire a big group due to the challenges associated with manufacturer framework agreements.
Penske’s comments highlight the future challenges for sellers of larger groups. I also noted during the recent public company conference calls that most of the publics are committing time and capital towards alternative investments, rather than US dealership acquisitions. Specifically, Sonic and Asbury are both developing used car platforms, Group 1 and Penske are committed to international growth, Penske plans to expand further into the commercial truck market, and AutoNation is focused on building its online (not brick and mortar) platform. Sellers of large groups will continue to compete with these investment alternatives, which may limit the capital available for future blue sky.
3. Buyers are Willing to Pay Steep Premiums for Top Luxury Franchises:
The luxury auto retail market grew 73% faster than the non-luxury market through July 2014. This is not surprising given that high income households have thrived during the economic recovery. Buyers believe the risks associated with top luxury franchises are lower and their earnings growth prospects stronger. Furthermore, according to my research, the top performing luxury franchises are achieving the highest average dealership profitability.
Based on data compiled from our buyer database, the luxury franchises in greatest demand are Mercedes, BMW, Lexus, Audi, Porsche, and Land Rover. As Chart 4 demonstrates, there is a limited supply of these top franchises, which further drives up blue sky values.
4. Many Indicators Point to Blue Sky Pricing Approaching Peak Levels:
The SAAR topped 17 million units in August, the highest level since July 2006, and total sales are up 5% for the year. Auto sales growth far exceeded many analyst’s expectations coming out of the recession. Unfortunately, many of these same analysts are now predicting slower auto sales growth for a number of reasons including: (i) the expected rise in interest rates, (ii) negative auto equity as a result of extended loan terms, (iii) student loan debt limiting car purchases; and (iv) improvements in car quality/longevity.
A Morgan Stanley industry report recently noted, “The U.S. auto cycle has clearly moved from a ‘need to buy,’ to an ‘I just want to buy’ type of consumer mindset. There is a dark side to all this.” I believe this dark side will put pressure on future dealership blue sky values. The timing of a sales decline could coincide directly with an increase in sellers coming to market due to age, putting further pressure on blue sky prices.
Our firm believes that the closer we get to a 17 million sales year, the closer we come to peak blue sky values. Dealers in their late 60s and 70s will not likely witness a better selling environment in their lifetime. One thing is for certain: the trends in this article will change and a buyer’s market will eventually set in. When it comes to the value of your business, timing is everything.