Dealers are exceptional at tracking their financials. They often recite from memory their monthly new car PVRs and net income, sometimes to the penny! They know their net to gross and net to sales ratios, as well as key balance sheet figures such as total inventory, floor plan and mortgage debt outstanding. They attend 20 group meetings to further track their metrics against their peers and pinpoint areas for improvement.

But dealers rarely bring the same kind of analytical rigor to their manufacturer’s financial statements. Few can tell you their manufacturer’s profit margin or, more importantly, how much debt their manufacture is carrying as compared to equity. This is surprising given that the financial health of a franchisor drives franchise value. A financially strong manufacturer usually means a financially valuable franchise.

Consumer creditworthiness and financial health is tracked through a credit score. Likewise, businesses creditworthiness and financial health is tracked through a credit rating. Recently, we all became very familiar with the importance of credit ratings when the U.S. government was downgraded by Standard & Poor’s. That downgrade was a stark reminder of the importance of good credit, whether you are an individual, business or the government.

A manufacturer’s credit rating is an indication of its ability to raise funds in the capital markets, as well as the cost of those funds. A high credit rating usually means a low cost of capital and strong access to capital, while a low credit rating means a high cost of capital and limited access to capital. So, why should dealers know and understand their franchisor’s credit rating?

Here are a few good reasons:

• Captive finance companies: Dealers rely heavily on their captive finance companies not only for floor plan, mortgages and acquisition financing, but also for consumer financing. When a captive finance company is well funded at a low cost of capital, it is able to support the dealer network in numerous ways. On the retail side, the captive can be more aggressive when buying retail paper to ensure retailers hit their monthly sales objectives. The captive can also lend generously towards real estate, acquisitions and floor plan (this became tremendously important during the last credit crisis). A strong captive can also play an important role when a dealer decides to sell the dealership. The captive can finance a substantial amount of the real estate and blue sky, often augmenting the purchase price. This is a significant point which will become quite clear when we look at the manufacturer’s credit ratings as compared to franchise blue sky multiples.

• Product investment: A well capitalized manufacturer can invest in the prerequisite research and development both to create innovative new products, as well as to reduce the product refresh cycle time. As Bob Lutz so aptly pointed out in his book “Car Guys vs. Bean Counters, the Battle for The Soul of American Business,” it is both product quality and design that creates a successful car company. Generally, the more successful the car company, the more valuable the franchise.

• Brand investment: Building a brand is expensive and is difficult to do without strong sales and available cash. Hyundai is the perfect example of this. As its sales and market share grew, Hyundai invested some of its excess cash flow in effective brand building (as well as better product). These investments are paying off, as the company’s financials and franchise value improve. The stronger a brand the easier it is for dealers to sell vehicles and the less the dealer needs to spend on advertising.

• Crisis preparedness: Strong financials provide a cushion in the event of a crisis. Nowhere is this more obvious than in the case of Toyota. Its incredibly strong balance sheet ($45 billion of cash on hand as of 6/30/11) and historical earnings enabled Toyota to weather not only a major product recall debacle but also the tragic tsunami. Many car companies would not survive these double whammies. The market recognizes Toyota’s financial stability and continues to award it the highest credit rating of all manufacturers, not to mention a very strong blue sky multiple.

When a manufacturer has a low cost of capital as reflected by a high credit rating, its franchises are usually highly valuable. The inverse is also true. When a manufacturer has a high cost of capital as reflected by its low credit rating, its franchises are usually much less valuable. Table 1 demonstrates this conclusion. It compares Moody’s* current credit ratings (8/23/2011) and The Presidio Blue Sky Multiples**, which are our estimates based upon recently closed transactions, current conversations with leading buyers, and Presidio’s opinion of these franchises’ future performance (Presidio recently completed its M&A Update for the first half of 2011 which includes a detailed discussion of these multiples. Please contact me if you are interested in receiving a copy).

Table 1: Moody’s Credit Rating* vs. The Presidio Blue Sky Multiples**

Source: Moody’s and Presidio M&A Update (8/23/11)

Clearly, there is a close correlation between a franchises’ blue sky multiple and its manufacturer’s credit rating. If you are a buyer of franchises, you may use this table as an indication of where you should invest your capital and the risk level of that investment. Alternatively, dealers can gage the value of their businesses today based on the financial fortitude of their manufacturer and determine if now is the right time to sell, hold or invest further in their businesses.

Just as Americans have a major stake in the creditworthiness of the country, dealers have a major stake in the credit rating of their manufacturer. Dealers should apply the same kind of analytical rigor to their manufacturer, as they do to their own business, especially if they are a buyer or seller. A financially successful dealership and a financially sound manufacturer are the two key ingredients for strong franchise value.