Cooling Off – Time To Build Reserves
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By Phil Villegas
After many years of the stability and brand performance parity, I sense we are going into a very interesting era for automotive dealers. While in my opinion there is a lot of fuss over “Mobility” and the virtual doom it has in store for a large percentage of the dealer network, I feel there is a more traditional and imminent threat to dealers before autonomous, subscription or ride-sharing services put a dent in the industry.
My primary concern relates to what appears to be a likely recession to come within the next few years. While there are varying schools of thought of whether a recession is likely, the reality is we currently find ourselves not too far from being in longest economic recovery in US history, close to 10 years. Despite this extended economic run, we are seeing other signs that bolster recessionary concerns like:
- Slowdown in U.S. retail vehicle sales
- Increases in vehicle inventory days’ supply and manufacturer incentives
- Steady rise in oil prices over the last few years
- Rising interest rates
- Stock market losing its gains for the year
While the U.S. economy is experiencing record high consumer confidence, partly fueled by record low unemployment, many economists point at this as being signs of an economy that is overheating and heading for a cooldown. While I do not anticipate a recession anywhere close to what we experienced a decade ago, I do believe a cooling is imminent.
Given that I subscribe to this impending recession school of thought, over the past few years our advice to clients has been to sell if they do not have succession plans with an outlook greater than 5-7 years. I cannot recall a time where the combination of blue sky multiples and tax rates were as favorable for prospective selling dealers.
For clients looking to invest in dealerships, we have cautioned them to hold off unless the opportunity they were considering was a highly strategic one in which the geographic or manufacturer dynamics were so rare that it could not be passed on. We have been advising clients to build their war-chests and wait for the next recession to hit prior to investing further in dealerships. We’ve stressed the emphasis to be on improving existing operations, where the return on investment will be more rewarding.
The reality is that blue sky multiples have still not corrected for greater outlook concerns in the market, particularly when you factor in continued declines in dealer profitability. The decreases in dealer profitability is not only coming from compressed gross margins on new vehicles, but also through increases in interest rates and higher wages.
With the drop in the unemployment rate, one of the greatest struggles dealers are currently having is not only finding qualified talent but being able to retain them for what is considered a reasonable wage in other industries. While finding talent has always been a challenge for dealerships, it has become more pronounced in the last 24 months, with a shortage of talent, wages have spiked in key administrative and management areas. As an example, the average salary expectation for a Controller in South Florida was approximately $120k per year in early 2017, as of today, the expectation is around $170k, yet the skill set of these individuals has not increased commensurate with pay. This added expense is rarely offset positively on a dealer’s financial statement.
Even if the next recession does not occur for three years, we do not anticipate blue sky multiples to increase from their current levels, rather we believe we are beginning to see their decline. We are also sensing the appetite from private equity money has significantly diminished, likely a fortunate byproduct of the “mobility” scare concerning some of the over-correctors.
So, if multiples are not expected to get any higher and dealer profitability is only expected to decline, the waiting game becomes a much more practical play. Just consider that a dealership transaction closed this month compared to February of next year could have a lower blue sky price by well over 20%. A current store would be valued based on either 2017 performance or 2018 annualized from mid-year, contrast that with a likely lower blue multiple in early 2019 and a full year 2018 that will likely be lower than an annualized mid-year estimate to the slowing retail environment.
If a recession does hit in the next two years like I anticipate, multiples are inevitably going to drop as dealerships that are currently struggling with profitability could significantly hemorrhage and be put up for sale. My prediction is that unless some of the private equity firms are also waiting on the recession in order to capitalize on the opportunity, they will be some of the first to put their stores up for sale. Through experience, we’ve found those with a segmented commitment to the industry tend to have the least tolerance during a downturn. Dealer’s who are committed to the day-to-day challenges and opportunities of retail automotive are the ones who are traditionally best prepared for changes in the market.