The “Perfect Storm”...

How did we arrive at the point where dozens of dealerships in New England either have closed their doors or joined larger groups in the past few years? Was this outcome inevitable? The simple answer is NO!

What was the Big Topic at NADA this year: Market Consolidation! What’s the topic that inevitably comes up when we talk to dealers and our clients? Market Consolidation!

It’s topic numero uno whether you’re a manufacturer losing market share or gaining it. And it’s the main topic whether you’re a dealer planning to acquire a store, expand a franchise, exit the business, or simply survive. These are difficult, even agonizing, decisions. But one thing is clear to The WIZ: to stand still in this environment is to risk losing everything you’ve built.

So, how did we arrive at this point, where dozens of dealerships in New England either have closed their doors or been consolidated into larger dealership groups in the last year and half, with lots more expected to follow suit?

Was this outcome inevitable? The simple answer is no, it was not inevitable. As The WIZ has said for several years, three developments came together to form “The Perfect Storm” that slammed the domestic auto industry.

A Monster Storm Sinks Dealerships

The first storm began to sink dealerships roughly one and a half years ago, as retail volume dropped precipitously but OEMs did not change their market representation policies to reflect the new paradigm. We see that a Ford dealership sold for $1 million blue sky, but today that dealership has shut its doors and the point is closed! What occurred over that brief year and a half period is not only dramatic but also irreversible.

For example, in the Brockton metro market south of Boston, we see an excellent example of failed Ford market representation policy, altering the landscape forever. Recently, five Ford dealerships have closed in the Brockton area, leaving two dealers to slug it out in Easton and Stoughton. In the end only one will survive. Had Ford tackled this situation ten years ago, Ford would have one excellent Megastore in an ideal location competing against the brand new Toyota store with a Honda store in the works. With your typical Toyota and Honda stores selling more than 1,600 vehicles, and the larger Nissan dealerships selling more than 700, compared to 300-500 units for most domestic stores in the same area, guess who builds the new stores… in the choice locations… and attracts the best talent?

Also, on the one hand, you have to admire GM’s North American Operations executive who reassures his dealers that GM won’t force, coerce, or pressure them to leave the business… but, on the other hand, at what cost? A few bucks well-placed would have consolidated key markets, leaving larger, more viable GM stores to compete against the imports. In the dozen communities just north of Boston, Buick-Pontiac-GMC now lacks representation, having lost three stores in this last year alone. Real estate prices pose a formidable hurdle to regaining a foothold.

Will the domestics follow the lead of the imports: more cars sold by fewer dealerships? Ironically, in this down market, it will cost the factories half of what it would have cost them three or four years ago to buy out a store. Yet they still hesitate to cut their dealer numbers, leaving themselves vulnerable to lost sales from an ever weaker, unprofitable dealer body!

The First Storm – Status Quo Precipitated Trouble

Back about 12 years ago J.D. Power & Associates, at its elite annual Automotive Dealer Roundtable at NADA, told Domestic manufacturers that their sales per outlet were headed down… way down. The opinion was that if the Domestics wanted to prosper, they would need to start consolidating dealerships. As painful as that may seem, J.D. Power warned, it would have been far less painful than what lay ahead otherwise. Power repeated the warning every year after that, but the OEMs ignored the advice and even continued to approve the smallest deals. In the market south of Boston, for example, Ford gave the green light to the purchase of several stores that sold as few as or fewer than 200 vehicles. FMCO should have bought those out and closed the points!

Remember… fast forward to summer ‘05 when Domestic manufacturers, led by GM, dipped deep into their small pockets and launched an “innovative” sales campaign to preserve market share: the Employee Pricing program. Not only did it prove expensive, but also did not preserve market share. The Domestic OEMs barely moved the needle!

The Gathering Storm – A Maturing Market

By early 2006, the second storm was driving its way into the retail market. The painful truth was that the retail market had reached maturity following a five-year bull run. Total sales including Fleet remained fairly strong, which made slipping retail sales difficult to recognize. However The Wiz, who holds a stethoscope to the market listening to its ever-weakening heartbeat and observing all the stats, noticed two critical factors emerging! First, per unit gross profit was dropping; and, it can only drop so far before your dealers look for other ways to make money. In addition, it must be pointed out that the industry from ‘05 to early ‘08 lost two million retail units (2,000,000)! The OEMs and dealers watched while retail sales dropped from 14 million to 12 million. By the time the new reality set in, Domestic manufacturers were losing dealers left and right and had little choice but to act.

The Rogue Wave – Imports Assume a Domestic Look

Around the same time, the third storm was gathering force with ever increasing speed and velocity! Imports – led by Toyota – began to advertise themselves as domestic car makers. After all, Toyota alone produces more than 1 million vehicles on American soil annually. They also greatly increased their advertising and incentives budget. Toyota and Nissan upped the ante dramatically beginning in late Winter of ‘06. Honda followed suit, but grew its business without placing as much money “on the hood.” Any way you slice it, these manufacturers-formerly-known-as-imports have roughly one-third the number of dealerships compared to volume domestic car makers, yet they sell a similar number of vehicles.

Is it Time to Build, Broker a Deal, or Divest?

Dealers who wait too long to decide upon a strategy risk being closed out by other purchase and sale activities around them. Where does the market breakdown leave dealers trying to gauge their position and the position of others in this new marketplace? More often than not, it leaves them confused. For many, the question comes down to whether to invest or divest. Not surprisingly, much of the time we used to spend brokering buy/sells is devoted now to developing market consolidation strategies and dealership valuation.

Most domestics are now worth a minimum of blue sky unless they are able to participate in some sort of consolidation program offered by their OEM or dualled with another franchise. Most importantly, dealers who wait too long to decide upon a strategy risk being closed out by other purchase and sale activities around them!

Tracking Local Market Dynamics

If you decide to divest, the choice comes down to selling or closing the point. Using a broker to negotiate with the manufacturer as part of a consolidation program can generate twice the blue sky compared to simply accepting the terms normally offer by the OEM.

What advantage does an experienced broker bring to the table? To begin with, their participation in and knowledge of many deals provides insight into what factories and other dealers have offered to dealerships in similar situations. Their knowledge of local market dynamics – including other pending and potential deals – used as leverage will help to sway a manufacturer or another buyer to pay more.

The Net Result of Re-Alignment

Total dealerships in Massachusetts from year ‘06 of 532 fell to 508 in ‘07 with the count down to 476 in the first quarter of ’08… an almost 11% drop in dealer count with ‘08 continuing to decline at an even faster pace! That scenario plays out all across New England!

This consolidation activity has serious consequences for stand-alone Brands. OEMs (especially Chrysler and GM) have declared their intention to focus on their Brand strengths, eliminating duplicate products and paring existing lines. For a stand-alone Brand with fewer products to offer, preserving market share will become impossible!

Find an Alpha/Genesis or Perish and
Beware of OEM Unrealistic Facility Policies

Just a year and a half ago, a stand-alone Dodge dealer could still expect to get blue sky for the dealership. It was viewed by the market as a viable franchise with a full breadth of car and truck product offerings in place. An acknowledgment that product cuts are underway and that Chrysler has a consolidation program permanently reduces the perceived value of the single Brand dealership. Today, that dealer is forced to find an “Alpha/Genesis” fit – or perish.

Today Tier One Import dealers also face their own dilemmas, such as whether to sink millions into a new facility in a declining retail market. Several New England Toyota dealers fear that their sales have peaked as market share has decreased and vehicle grosses have declined precipitously this last twelve months, and are reportedly backing away from breaking ground. A recent article in Automotive News confirms that the recession is putting a damper on capital spending for new or redesigned Toyota stores. Minimal redesign can cost $2 million, while a tear-down runs between $5 million and $15 million. Relocation will add $10 million to $20 million more in costs. It’s an especially difficult decision for Nissan dealers, whose OEM has the reputation for being “brutal” in its demands for building new facilities while market share remains static! Honda, on the other hand, has made consistent inroads in the market, and consequently has made its franchises more attractive to dealers. It spent the least in incentives per vehicle among Tier One domestics or imports… and notably, its dealers are not balking at facility demands.

Where Values Are Headed

In the near-term, Chevrolet dealerships will see increased blue sky value as Chrysler and Ford continue to lose market share and new, more innovative Chevy products gain more acceptance. The “surviving” Ford dealers will see blue sky increase modestly as gains are seen in the size of the market areas as Ford dealers terminate. Chrysler dealers who are fortunate to “participate” in the “Alpha/Genesis” consolidation program will see their blue sky increase in the near-term for the same reasons – larger sales localities. Importantly, in the Boston Metro area Chrysler dealers have been told that Chrysler will consolidate their stores down to 10 from a recent 30. For those domestics in the right markets and participants in the consolidation programs, their franchises will see increased in blue sky value from near zero to three times earnings over the next two years. Toyota and Honda blue sky value will remain static at seven or eight times earnings, while Nissan will remain at four times earnings.

Other Tier Two imports and domestics are more difficult to predict because their valuation varies widely because product introductions and entries are less consistent across car and truck segments. One valuation difficulty is that many Tier Two OEMs will not allow full or even partial dualling, so lower sales per outlet equals marginal profitability, producing low blue sky values. Mitsubishi is still being evaluated by the market even as sales recently increased from prior anemic levels. Mazda, however, can be worth upwards of three to four times earnings as continual sales increases have buyers viewing the Brand as a rising star. A year ago two Hyundai dealerships sold for strong blue sky but both had desirable real estate, clearly demonstrating that important fact in valuing dealerships. Real Estate plays an even more pivotal role in Tier Two (or Three) deals than for Tier One dealerships.

Private Equity – The New Funding Source

The size of deals nationally – and more gradually in New England – has begun to attract private equity investment during this consolidation period. Many banks are simply unable to finance these larger deals without leaving their safe base of “asset lending” by turning to “cash flow lending”. One recently completed large deal in the Boston Metro involved a $200M investment, most of it through a local private equity firm. That capital was enhanced by cash-flow-based lending from a traditional local bank, to be used for working capital.

Private Equity funding will take on increased importance because of consolidation. The larger deals now more common through consolidation efforts by OEM’s and in turn by the acquiring dealers are achieving the “market mass” that private equity investors look for. Traditional local banks that don’t participate in the newer financing “facilities” clearly risk being left behind in the new paradigm!

Private Equity Investment is today’s IPO for middle-market sized deals!