Growth with other people's money: capital markets' view of automobile dealerships
NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
During the past year the liquidity and prices of automobile dealerships have reached unprecedented levels.
This highly beneficial development for dealership owners has been prompted by the ascent of a new auto retailing giant, Republic Industries, initial public offerings of common stock which raised more than $700 million for auto retailers, a relentless stream of acquisitions, and the introduction of several well-capitalized financial groups seeking partnerships with dealers.
What has Changed?
The industry has begun to consolidate, which many believe will fundamentally alter the face of future auto retailing. Large, well-capitalized companies will own multiple brands in numerous regions. These companies will offer a full range of services, including “in-house” financing, insurance, parts distribution and a secure supply of reconditioned used vehicles. They will be fully integrated through information systems which will provide operating and financial data both on departmental and consolidated bases. Customers will begin to recognize national logos, and new “company cultures” will evolve with an emphasis on consumer satisfaction and quick delivery.
Because of the introduction of public funds and financial investors, a larger pool of capital than ever before is available for investment in the industry. In the past, dealers themselves usually financed acquisitions and growth through in vestment of personal funds and earnings for existing operations. Buyers for dealerships tended to be other dealers in the same market area. these buyers incurred a high degree of personal risk. Consequently expansion was primarily conservative and local. With outside sources providing the increase in available funds, acquisitions, expansion and pricing have become more aggressive and national in scope.
Prices paid for auto dealership have increased as a result of the current changes, not only because the cost of those funds has decreased (i.e., the pooling of public capital has reduced the perceived risk). Consequently, investors can pay higher prices and still anticipate acceptable returns. Furthermore, the inherent economies of scale in larger operations allow today’s buyers to price dealership on higher “adjusted” earnings that reflect those efficiencies. As a result of the increase in the number of viable buyers, there is the possibility of creating a more competitive bidding environment which pushes prices up. Prices in the private market have doubled in some cases as a result of these factors.
There is always a difference in pricing between the private and public markets, primarily due to the degree of liquidity. today’s buyers are able to take advantage of the arbitrage between what a private seller receives and what is valued in the public market. There are two common scenarios. a public company may acquire a private company at 4 to 8 times earnings before interest and taxes, and have those earnings valued in the public market at greater than 12 times.
Second, a financial investor may acquire a group of private dealers at the same 4 to 8 times earnings before interest and taxes, and then be taken public at 12 times the same pretax earnings. In both cases the acquirer receives the benefits of the difference in pricing between the private and public markets.
The dealership’s size no longer affects the owner’s ability to sell. Previously, transactions were primarily for single franchises; owners of large groups bought and sold franchises piecemeal, one dealership at a time. Today’s buyers are capable of buying multiple brands and locations, often placing a premium value on larger retailer’s earnings.
What are Buyers Looking For?
Today’s buyers, whether it is a large industry player or a financial investor, are looking for a “growth platform” from which they can manage acquisitions and expansion in the local market. Because of the speed with which acquirers are expanding there is a need for strong management. Buyers are looking for management who will stay in place and be responsible for identifying potential “add-on” acquisitions.
In addition, buyers are looking for profitability, particularly publicly-owned acquirers. There are many ways to evaluate profitability and consequently quantifying a group’s profitability is difficult. Historically dealers have managed their income statements to show as little earnings as possible in order to reduce their current tax liability. However, publicly owned companies and financial investors seeking high returns are interested in managing the income statement to maximize earnings. Therefore, a dealers’ profitability that is used for a valuation may include numerous adjustments. The most common adjustments are for non-recurring expenses, compensation that would not continue, LIFO inventory expenses, related-party expenses and additional earnings that recent operational improvements or recent acquisitions will generate.
Who are the Investors?
Public companies like Republic Industries, United Auto Group, Cross-Continent Auto Retailers, Lithia Motors and CarMax are acquiring dealerships throughout the country in an effort to increase earnings and gain market share. Public companies will pay owners with cash, notes and the stock of their company. In most cases there is a strong need for the owners and management to stay with the company and participate in maintaining the profitability of the operations and assist in identifying additional expansion opportunities. The primary risk associated with the public companies is the initial lack of liquidity of any stock used for payment, and the volatility of that stock while an owner retains it.
Financial investors use pools of capital from institutions and individuals to invest in dealerships. Payment to the seller is primarily with cash. The structure may include a partial purchase of the company with the remainder retained by the existing owner. This structure provides some liquidity to the owner and the opportunity to gain from any increase in value of the business through the retained ownership. In this case the continuing participation of the owners and management is nearly mandatory.
“Roll-up” groups attempt to combine a number of dealerships and owners together to gain size and profitability with the objective of going public. Each owner receives some portion of ownership of the larger entity. By going public the total group is able to raise cash for expansion and, over time, a market for liquidating their shares. The primary risks associated with this strategy are related to the uncertainty of successfully taking the company public, and furthermore with the volatility of the stock retained.
The opportunity for private owners of automotive dealerships to liquidate the value accumulated in their businesses has never been greater. The drive for consolidation and the introduction of public funds into the market has driven acquisition prices to the highest level ever in the history of the industry. For the first time there are alternatives available to owners of dealerships that vary in risk and potential return. Finally, the capital that is being deployed for this consolidation is coming from a source other than the dealer’s own sources.
This article was written in 1997.