By Ben Redman and Thomas England, DHG
With such an abundance of consolidation, buying, selling, brokering and new investor entry, the automotive space has presented exciting opportunities over the past few years. Given the rise in private equity/family office (PEFO) activity there are many new investors who are new to the space and may find an “inside scoop” from a dealership accounting perspective helpful when it comes to grasping the distinctive industry language and effectively analyzing the investment opportunity.
A good place to start when bridging the gap between the industry’s newer participants and some of the dealership space’s more unique characteristics is to run through a few key accounting considerations that may provoke constructive conversations surrounding the merging of the dealership and PEFO ecosystems. The following items are what we consider to be the most pressing when it comes to familiarizing a new PEFO investor entering the dealership arena:
- The Dealer Financial Statement
The dealer financial statement is intended for operational purposes. Consider it a guide that tells a story about each department within the dealership. Although it is all-encompassing, it is important to analyze it in segments. For example, a dealership financial statement may show four different profit centers that share common expenses. Nonetheless, each profit center must be analyzed independently – despite the common denominators. This can cause some difficulties as there might be some “below the line” income or expense items that relate to multiple departments which may or may not skew the margins or profitability of individual departments. As the dealer, financial statements may not align to general ledger reporting and/or Generally Accepted Accounting Principles (GAAP), they are designated as operational management reports.
- Manufacturer Guidance
Manufacturers supply accounting manuals that don’t always align with the GAAP. In fact, some manufacturers might “nudge” or outright permit dealers to record deals in the prior year that were sold the first few days of the following month. These practices often lead to reconciling items when comparing to audited or reviewed financial statements.
- Cash, Cash and More Cash
With the overwhelming number of cash transactions that run through a dealership, dealers often perform daily bank reconciliations. PEFO investors often, and rightfully, inquire how much cash a typical dealership needs to run day-to-day operations, which can be difficult to concisely address given variables such as contracts in transit (CIT) collection; frequency of incentive pay by the manufacturer; floorplan payoff terms; accounts payable turnover; historical chargebacks; self-funded warranty products and more. One suggestion is to start by referring to the dealer financial statement, where required manufacturer financial covenants are typically stated on page one.
- Inventory Analysis
Let’s start with analyzing new vehicle aging. New inventory analysis should dig deep and consider items such as model year and product mix compared to the store’s current market. Looking at national averages can be ineffective as trucks, for example, might be selling well in Southern markets but not as well nationally.
Used cars, on the other hand, can be more straight forward. Nevertheless, you will want to factor in that dealers can make money through favorable trade-in value, and could earn more than the vehicle’s worth in the deal’s entirety (selling the vehicle, F&I add-ons, etc.).
As many dealerships, don’t have systems in place to provide this information in real time, we recommend analyzing whether obtaining this historical information is worth the time and resources required – especially when analyzing inventory from some of the industry’s more challenging years (’08, ’09, etc.).
- Floor Plan Financing
While analyzing a floor plan statement, an investor might notice how rates greatly vary depending on the financer. In addition to observing the interest rates, consider key items such as:
- Additional incentives paid that offset the floor plan rate that are not recorded as a reduction of the interest paid
- Cash management account (CMA) balances reducing the rate
- Overall manufacturer relationship that may help dealership profit, such as better product, more product, or additional points
- Manufacturer Incentives
So much hinges on the details of a manufacturer’s incentive program, especially as the manufacturers tend to vary programs annually. For the sake of the PEFO analysis, consider asking the dealer questions such as:
- Which incentives do you receive on a recurring basis?
- Are these incentives based on purchases, sales, customer satisfaction index (CSI) scores or any other requirements?
- When are these incentives paid?
- When do you record the payments?
- Have you ever received any facility assistance? If so, how did you record it?
Dealers may also have different strategies for different stores, such as increasing units in operation in efforts to achieve volume incentives set forth by manufacturers. Other dealers may not implement the same strategy, which is a choice that may likely be dependent on management, market or manufacturer pressures. PEFO professionals might also consider asking: what happens when the dealership misses the volume incentive, or if the incentive changes?
- GAAP vs. Income Tax Basis
The difference between the dealer financial statements and the audited or reviewed financials can be drastic. Depending on the main goals of the dealer, there can be significant differences between dealers focusing on tax savings vs dealer’s focusing on profit. Alternatively, there are ways for dealers to “smooth” monthly earnings that don’t affect the dealer financial statements. This, in turn, can cause a large swing from the December statement to the infamous “13th month”. Examples include:
- Pack reserves
- Recognizing manufacturer incentives
- Buildup of prepaid expenses that are recognized as expenses in the 13th month
- Only truing up reserves annually (inventory, F&I chargebacks, etc.)
Performing a deep dive into the accounting treatment of the financials and looking at a GAAP financial statement (whether it’s an audit, review or compilation) can help new investors better understand the margins.
- Other Income
When analyzing financial statements, other income can appear as a significantly larger line item than normally incurred. It could be a direct result of:
- Larger income pickups, which can be from accruals needing to be brought back against expenses, manufacturer facility assistance income, overfunds from a reinsurance retro programs
- Significant expenses usually non-operational one-time expenses
- An accumulation of miscellaneous items that may have a meaningful margin impact if captured at a gross level in sales and cost of sales
- “Other” income that management doesn’t want affecting managers’ pay plan
Alternatively, it can be tough to accurately identify a home for these numbers. Further, it can be time consuming to remap the numbers to be in accordance with GAAP within the financial statements. Consider the availability of data and time commitment to align mapping of accounts to the financial statements.
Understanding these “other” numbers and attempting to recast them, if possible, can be helpful. At a minimum, wrapping your arms around the composition of each account should help ensure that it’s modeled correctly in any potential transaction. Keep in mind that most manufacturers will request that specific incentives be recorded in a certain place. Additionally, compensation and incentive plans for employees can be based on the gross profit numbers, which is something many dealers consider in conjunction with the bigger picture of the financial statements.
- Looking Beyond the Books
In addition to analyzing financial statements and manufacturer reports, aim to assess and gain a perspective on key, relevant items outside of the financial records. Next, ask what resides outside of the balance sheet. Perhaps it’s over remittances, facility rental agreements not being recognized at market rates, or related parties.
As with any specialized industry, there are many items to consider when entering the dealership space and evaluating a potential investment. With respect to timing, we recommend factoring in the extended period that is often required to get manufacturer approval. Identifying diligence teams with industry experience can also make a tangible difference in getting work done efficiently and effectively.
Whether you’re a seasoned industry investor or new to the space, the items presented here serve as a great starting point to facilitate conversation and unite the accountant and investor mindset to identify opportunity and complete a smooth transaction from start to finish.
DHG Transaction Advisory helps middle market companies across many sectors to deal with transaction complexities including accurate accounting, state and local tax compliance, and failure to deliver or receive expected results. DHG Dealerships serves more than 1,500 rooftops across all 50 states, representing dealerships of all sizes.