Predicting the Next Recession
Optimism is high heading into 2015, with dealership profits approaching historical records in 2014. But as we all know, there is an inevitable ebb and flow to economic and automotive cycles. So here’s a question for dealers: How much of your current net worth would you bet on the length of the current economic upswing and the severity of the next downturn?
Right now, the U.S. automotive industry is within striking distance of the all-time sales high of 17.4 million new vehicles, a record, according to the National Automobile Dealers Association, set in 2005. We are at least likely to exceed the 16 million new-unit sales mark this year. Keep in mind that roughly 20% of all franchised dealers closed their doors between 2008 and now, meaning that those 16 million new units are now spread over 80% of the dealers who were in business on the eve of the Great Recession.
Simple math dictates that new units sold per dealership, on average, are well above the previous highs. And let’s not forget the discontinued marques, including Pontiac, Oldsmobile and Suzuki, as the units their dealers sold have been reallocated among the remaining brands. It’s one of the reasons the financial health of the industry is so robust.
When things are going so well, it’s difficult to remember the bad times or imagine that they will ever recur. Sadly, we are all reminded during every economic cycle that “trees don’t grow to the sky.” As healthy as our industry is, another economic downturn of unknown severity will occur, and likely in the foreseeable future.
We know that auto industry cycles generally coincide with U.S. economic cycles. We also know that cyclical downturns in the auto industry are considerably more severe than the downturns in the general economy. Take the downturn we experienced during the Great Recession. The peak-to-trough decline in the U.S. gross domestic product (GDP) was 4.3%, while the peak-to-trough decline in U.S. vehicle registrations was approximately 36% (16.5 million units in 2007 vs. 10.6 million units in 2009). In other words, when the U.S. economy gets a cold, our industry gets pneumonia.
I am often asked in meetings and at conferences whether there is a way to either predict or prepare for the inevitable downturns. While it is impossible for mere mortals to accurately predict the timing or severity of the next downturn, there are certain broad observations we can make that are instructive. In fact, looking at the history of U.S. economic cycles between 1969 and 2014, we can state the following:
- There have been seven recessions between 1969 and 2014.
- These recessions have had durations ranging from six months to 18 months.
- The peak-to-trough decline in GDP during these recessions ranged from 0.6% in 1969 to 4.3% in the Great Recession of 2008.
- The “time since previous recession” ranged from a low of one year in 1981 to a high of 10 years for the 2001 recession. Note that only the 2001 recession came more than eight years after the end of the prior recession. And only the 1969 recession was more than seven years after the end of the prior recession.
- The Great Recession officially ended in June 2009, which means we are now just past the five-year mark in the current expansion.
- During these seven recessions, the decline in U.S. registrations ranged from 1.9% in 2001 to 21.4% in 2009.
Although it is impossible to say with absolute certainty, this history of the 1969–2014 economic cycles might lead a prudent man to conclude that we are likely within a few years of the next downturn and that there is a very high probability it is not more than five years away.
Feeling the Impact
These economic contractions have a number of consequences for dealers. The first and most critical is, depending on the length and severity of the next downturn, the survival of a number of dealers can be at risk. That’s why prudent dealers ensure that they have significant cash reserves to weather the inevitable storm. This may require dealers to strike a reasonable balance between expansion of their empires, expenditures on toys and hoarding away enough cash to weather the next “winter storm.”
The second major impact of significant recessions on dealers is the potential hit to their dealership valuations. It is no secret that dealership valuations are largely based on blue-sky multiples applied to either recent historical, or projected earnings based on market area potential and industry benchmarking operating metrics.
Keep in mind that between 2009 and 2013, the average pretax profit per dealership grew from $402,000 to $932,000. In the event that the profit of the “average dealership” declined back to the 2009 level of $402,000 in the next downturn, average dealership value would experience a decline of 57% — assuming that valuation multiples remain the same.
However, valuation multiples generally do not remain the same in recessionary downturns. Depending on the specific franchise and the severity of the downturn, the valuation multiples may contract by as much as 50% or more. This compounds the valuation shrink for a dealer by perhaps double.
For clarity, let’s assume a dealership currently makes $1 million in pretax profit with a blue-sky valuation multiple of 5X. It is simple to conclude a value of $5 million for this dealer’s blue sky. Now let’s assume that the next recession occurs and that pretax profit has declined to $500,000. Let’s also assume that the blue-sky valuation multiples contract from 5X to 3X. This hypothetical dealer’s blue sky is now only $1.5 million, a decline of 70% from his peak valuation.
For the large dealer groups with access to capital and deep management teams, these downturns may be just a temporary irritation. They may even present a nice buying opportunity at depressed purchase valuations. For other dealers, even those who have the resources to survive the downturn, these cycles can represent considerably more than a temporary irritation.
At any point in time, a certain subset of the dealer body will be considering selling for a variety of reasons, including retirement, estate planning, health issues, marital dissolution and liquidity needs for nonautomotive investments or problems. For these dealers, a significant recession can force them to choose between selling at a significantly depressed value or postponing the sale for as long as five years. Note that even though the Great Recession only lasted 18 months, it took six years for U.S. new-car sales and dealership profits to fully recover. Many dealers can afford to wait it out but some inevitably cannot.
For dealers who are in business for the long haul, one could observe that now is the time to use record profits to fortify balance sheets and cash reserves and to focus on dealership operating efficiencies. The dealers who do will be well fortified for the next downturn.
For dealers who are contemplating a possible sale in the “next few years,” it is useful to contemplate where we are in this cycle and to recall that cycles always end — and, for our industry, often very badly. Sale multiples are now at all-time highs, capital is readily available for buyers, and dealership earnings have rebounded to near all-time highs depending on the specific marque. Based on these facts and observations, an interesting rhetorical question for dealers who might be considering a sale in the next five years is: If not now, when?
J. Michael Issa is a principal at GlassRatner Advisory & Capital Group LLC and is the automotive practice group leader. He has won two Middle Market Deal of the Year Awards for M&A transactions. Email him at email@example.com. Patrick Lacy, an associate at the firm, assisted with the research for this article.
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