Since the fourth quarter of 2009, we have begun hearing about the next wave of dealership consolidation. The public companies continue to report their interest in acquisitions, though they are admitted “bottom fishers.” Similarly, many private dealers are seeking opportunities to expand their groups, capitalizing on the old adage “buy low and sell high.”

I am not surprised by this consolidation drum beat. Auto retail benefits from consolidation and here are some of the reasons why:

• Economies of Scale: Consolidation provides dealership groups with significant economies of scale, particularly relating to advertising, technology, dealer management systems, and outside services. With these economies, the publics have been able to achieve 3% EBIT margins, double the industry’s 2009 average of 1.5%, even with the additional cost of public reporting. Larger dealership groups also tend to operate larger dealerships (average annual new vehicle sales per dealership for the top 20 dealership groups is over 900). As a result, the economies at the dealership-level are also very attractive. For example, advertising spend per new car sold (see Chart One) at large dealerships is 70% below the industry average. 

Chart One: Advertising Expense per New Car Sold in 2008 by Dealership Size 

• Marketing System Sophistication: With the onset of the Internet, the way in which dealers obtain new customers is dramatically changing (see Chart Two). A more complex marketing environment gives larger groups a competitive advantage. As auto retail migrates to customer relationship management and direct marketing systems, stand-alone dealerships will be financially limited in their ability to hire expert staff and invest in expensive technologies, particularly given that many of these systems will require a certain scale to be cost effective.

Chart Two: Dealer Advertising Spend By Medium 1998 versus 2008

• Brand Diversification: Dealership groups are best positioned when they represent multiple brands across the economic spectrum. Brand diversification minimizes the risk associated with a single manufacturer. Even the strongest franchises can experience challenging periods (as we are learning today). Broadly speaking, the fall of one franchise is often offset by the rise of another.

So, if there are so many benefits of consolidation, why is today a good time for the next wave? Here are a few reasons:

Improved Sales Environment: Most experts believe 2009 was the trough year for auto retail sales (auto scrappage exceeded new car sales for the first time since World War II). New car sales are projected to grow at a 10% CAGR over the next 5 years. Moreover, at the dealership level, the growth rate will be even stronger (projected at 15%, surpassing 2005 levels – see Chart Three), due to the 15% decline in the number of dealerships.  Fewer dealerships will also lead to increased profitability. Dealerships are expected to increase market share in the high margin service business and experience less competition/pricing pressure on new car sales.

Chart Three: Average New Car Sale Per Dealership

Pent-Up Seller Demand:  Since the public company consolidation of the 1990s, there has been a dearth of buy/sells in auto retail, resulting in some pent up seller demand which will only increase as the baby boomers start to retire. After rapid expansion, the public dealership groups retrenched during the 2000s to focus on operations and profitability, becoming net sellers of dealerships as they trimmed their portfolio of unprofitable stores. When the publics left the market, few private buyers were willing to pay the high valuation multiples previously offered by their public competitors. More recently, the credit crisis, the Great Recession and the Detroit manufacturers’ financial challenges significantly limited buyer interest.

“New Normal” Dealership Valuations: Valuation multiples have declined significantly since the last wave of consolidation to an average of 5 times trailing twelve months earnings, with top imports trading for 4-6 times earnings and some franchises trading for as little as asset value. Sellers have begun to accept these lower valuations as the “new normal.”

Given so many compelling reasons to acquire dealerships and build a dealership group, who are the likely buyers? Today, the public dealership groups have access to capital; however, most are limited by their manufacturer framework agreements. As such, many publics are selectively purchasing franchises to round out their portfolios, but are not planning a large scale acquisition program. Alternatively, private dealers with less framework limitations cannot access sufficient acquisition financing (particularly for real estate) and are hesitant to risk equity capital.

As a result, there exists somewhat of a buyer vacuum in today’s market. Single-point dealerships may have an easier time finding buyers, but larger groups will be challenged. In fact, large groups may be required to break-up their enterprise to consummate a sale, receiving no consideration for the enterprise value created by virtue of their scale and highly developed management systems. Given this vacuum, I believe we will see new capital entrants in our market, primarily in the form of private equity. Though some dealers are skeptical of these Wall Street-types, we have learned that industry outsiders can be effective (just look what Mulally did for Ford). Regardless of your views on private equity, sellers should be happy that buyers are likely on their way. If you aren’t selling, be prepared. Bigger competitors may be coming to a market near you.