AICPA Dealership Industry Update
November 7, 2019 | Stuart McCallum
The 2019 AICPA Dealership Conference included many talented speakers and insightful topics. Below is a summary of the salient points from the presentations. For more details, please reach out to the HHM Dealership team.
- China hit 30 million SAAR before dropping to around 23 million this year.
- Europe continues to struggle, recently hitting a multi-decade low due to the strict regulatory environment and fallout from the diesel-gate scandal at Volkswagen.
- The negative sentiment about declining global SAAR was overblown, with SAAR increasing some.
- China car ownership is still only a fraction of other countries, with a majority of customers being first-time car buyers. China accounts for one third of global automobile industry.
North American SAAR
- Most gauges on the health of the North American auto industry are currently strong.
- US incentives have historically been increasing, but they’ve been coming down since August 2018. There are some monthly ups and downs, but the trend has been positive. As a percentage of vehicle transaction price, the trend is downward.
- Strength in the used market is unique to the United States. Economists believe this is due to the strong labor market – some people simply need a way to get to work and used vehicles best fit their budgets.
- SAAR does not appear to be overly reliant on subprime loans, making up only a small percentage of total loans.
- Thirty-day delinquencies have declined almost every year since the financial crisis, despite the “thematic narrative” being told by the media. Delinquencies are hovering around 2%, compared to approximately 3.25% in 2009.
- SAAR has stalled a bit around 17 million for several years, which is around the peak in 2007. The positive factor is that there are 20% more people in the US than in 2007. Seventeen million SAAR is consistent with “normalized demand.”
- Normalized demand implies a SAAR of 16.5 to 18.2 million vehicles based upon a sales-per-capita analysis.
- GDP analysis, or the relative share of GDP consisting of automotive retail, implies 17.3 million SAAR. The ratio of automotive retail to GDP has been relatively consistent since the data started being tracked in 1967.
- There are approximately 278 million cars on the road in the United States. The number of vehicles has only ever declined five different times – four years during WWII and in 2009.
- Electrification could present immediate opportunities to dealers to expand offers and line-ups long before it’s a net negative.
- There is likely an overemphasis on battery only power sources, but range anxiety will keep internal combustion engines in the conversation for a long time. Hybrids will benefit dealers with sales and fixed ops.
- Used vehicle sales are expected to be constant and maybe a growth area for the publicly traded companies. Many are expecting to see margin compression as more dealers get into the retail of used vehicles. The compression will come from dealers bidding up the price/value of used vehicles in the market.
- Analysts believe that F&I may have reached a ceiling, whether it’s due to the inability to get financed (with negative equity) or political pressure if a far-left leaning candidate wins the presidency.
- SG&A will be the main avenue available for increasing or sustaining overall profitability.
- AVs are not in the near future – the vehicles in design now will enter production between 2022-2024 and sell for 5-6 years. Looking at the current R&D pipeline, battery electric vehicles will account for approximately 7-9% of the total. 2030 is expected to represent a sizable shift toward electric vehicles, reaching close to 30%.
- Full scale paid search campaigns can be a benefit to dealers.
- 38% of customers on mobile use Google to look up store hours
- 35% look up vehicle pricing
- 33% look up accessory pricing
- Issue coupons that are only good for off-brand vehicles (LOF, alignments, tires, etc.)
- An example dealer generated $12,000 in additional gross in the first 30 days of using a full scale paid search campaign.
- Efficiency tips
- Preload service departments – Preload service departments with vehicles and supplies for the morning shift. Entry level techs on the evening shift bring vehicles and rack them. If possible, have the techs lay out supplies and specialty tools.
- Premade recall tool kits – Parts and toolkits for recall work to help build efficiency with younger/lower level techs. Most recall sheets list the tools and supplies necessary for the repair. Nonscientific results suggest that a kit can save 10-15 minutes per service.
- Digital service scoreboard – A prominently displayed ranking of service technicians by weekly performance metrics. Have the service manager stand in front of the display regularly so that techs know that the rankings matter. Further incentivize techs with cash bonuses for both ranking and rank improvement.
- Services and processes
- Free alignment checks – Some dealers are offering free alignment checks, but increasing the price of the actual alignment. One dealer offers $5 bonuses for every alignment sold and a $150 bonus to the top seller each month.
- Appointment books – Have the BDC create packets for the customer appointments they set. The packets are handed out to the sales professionals on the morning the customer is scheduled to come in. Packets include CRM notes from the call, customer contact information, information on the trade, information on the target vehicle, and if they are a repeat customer. Have the car ready for when the customer arrives.
- This is a good process, but what’s most important is that they have a process.
- Trade-in packets – Some dealers send customers home with prepaid envelopes so they can mail back the keys to the trade-in. Some use larger FedEx packages because they’re more substantial and won’t get lost as easily.
Trends in Auto Retail
- New gross PVR has improved for most franchises, yet laggards such as Kia and Mitsubishi have weighed down the average.
- Used gross is down because of the competition at auction to acquire inventory. This is forecasted to continue.
- F&I at the public companies have seen some pretty consistent growth of 5% per year. Captive insurance companies at private cap dealers have provided growth on top of that. With improved manufacturing quality in recent years, domestic brands are seeing strong profits from their captive programs.
- Fixed operation growth is tracking around 4.3% despite SAAR leveling off/declining. This implies that the fixed operation growth at the franchised dealers must be coming from conquests stolen from independent repair shops, which still make up a large portion of total vehicle repairs.
- Advertising has been a net positive for dealers as it has declined as a percentage of gross profit. Digital advertising, and the move away from expensive traditional media, appears to be the main driver.
- Rent declined, yet this is not likely to be a trend. This is possibly due to a tax play after President Trump’s reform. Dealers continue to invest heavily in their facilities, both in image and size, so it is expected rent will weigh down profit in the future.
- Quarter two saw a 60% decline in M&A activity. This was led by public’s decreasing their acquisition spend by 55% during the first half. Over the past 18 months, the public companies have sold 55 stores while only buying 34.
- Buying activity tends to be toward single points and domestic stores. These may have been tuck-in acquisitions that were easy to justify.
- Interest in luxury stores has diminished as investors look for greater ROI potential and to diversify away from potential tariff risks. We know of two deals that terminated due to tariff concerns.
- Stores per dealer have increased by 25% over the past 10 years, with the average dealer owning 2.13 stores in 2018.
- Demand for stores remains strong. Values slightly increased in Q2, supported by both demand as well as an increase in average store profitability.
- Stores without earnings may not trade at a multiple, but at some level of flag value. Depending on the facts and franchises, you may be lucky to get the fair market value of the real estate. Some franchises likely require a haircut to the real estate value.
- Year to date stock performance for the public franchised auto groups has been better than the S&P 500, yet still lags behind the performance of the groups dedicated to retailing pre-owned vehicles, such as Carvana and CarMax. Carvana’s market cap is almost the same as all of the public franchised dealers combined.
- There is significant talk about the risk of EV’s and AV’s but there isn’t a dealer we know who has been negatively impacted by these vehicles.
- Uber and Lyft may be superior to renting a car at the airport, while still remaining inferior to buying a car.
- Customer experience – Younger folks use their phones to click and buy everything in their lives. Cars are no different. They don’t want to negotiate for anything.
- OEM – Many dealers are already feeling the pressure of the OEMs. Front end profits are almost exclusively the result of factory money. We know of some dealers selling into their holdback. Many dealers can’t even tell what their maximum profit is if they hit all of their goals. Dealers are selling at losses without knowing what the categories are even worth. Several dealers now have executives dedicated to tracking incentives.
- People – Changing work habits and desired career opportunities are keeping younger people from exploring our industry. Outsiders may not realize the income potential, for example, that a person without a college degree can make north of $100k selling F&I products.
- Jobs should be more than a job. Companies should have a “purpose” and provide some path to work/life balance.
- Sales professionals are often depicted as immoral and unethical in the media.
- Commissions are a turnoff for younger professionals.
- Carvana – Carvana is in 145 markets and is expected to sell around 190,000 vehicles in 2019.
- Their gross profit per vehicle has increased by thousands in only a couple of years.
- The CEO recently issued a gift of $30 to employees as a thank you for the improved performance of the company. This sounds like a good place to work.
- ROI, on both a levered and unlevered basis, continue to be strong, ranging between 12.7% and 31%, depending on facts and circumstances. This is much greater than dealers can generate anywhere else.
Tips to beat the threats
- Preparing for sale – Maximizing value. There are a few things dealers can implement without their control.
- Cut the fat – If there are people on the payroll who wouldn’t keep that level of compensation, or the role, under anyone else, then make the decision now.
- Focus on growing fixed ops.
- Invest in training for F&I professionals.
- Limit the investment in facilities.
- Run a competitive transaction process.
Fixed Absorption and Profits
- Most dealers come from the front of the house and usually have a financial statement on their desk. Most service managers don’t know how to read a financial statement. When is the last time your service management got to even look at a statement? If you can’t answer that question, then how can they know how to improve the results of their department?
- Driving traffic is usually the go-to answer for service managers. Traffic can come at a loss if they’re issuing coupons or trading gross for SG&A.
- Service writers should average around 12-15 RO’s per day.
- Quick lube sees the highest volume, but when is the last time the most qualified person worked that lane? That quick lube sees the most cars and touches the most vehicles, but the inspections, repair work, and write ups are likely done by the least knowledgeable/experienced professionals. How can you sell in the lane if they don’t know what to look for? This could be one of the largest opportunities at dealerships today.
- Instead of total gross, try calculating profit per labor hour. This will tell you if SG&A is consuming the incremental gross your manager is trying to generate.
- Customer service in the service department is bad. When a customer pulls up, 10 out of 10 times the first thing they hear will be “Do you have an appointment?” This has a negative connotation, as if we are going to send them away if they don’t. You’re going to take that customer regardless of their appointment, so start the customer interaction with something more positive.
- 70% of customers will switch to an independent repair shop after the vehicle falls out of warranty. This means the service department has a large opportunity to improve customer retention.
- Divide your techs into teams and coaches. Create a competitive environment that drives the teams to want to do better.
- Independent dealers have a much greater ease to work with compared to your average franchised dealer that tends to be impersonal and rigid in structure. They also have a neighborhood narrative that larger dealers just don’t have.
- Internal repairs should be billed at the same rate as customer pay, but you don’t have to pay clerks, writers, or the best technicians so the profit potential is huge.
- Commodity services should have lower profit than add-on suggestive selling items like alignments. Pricing strategy matters and you should upsell as appropriate for your markets. In colder markets, writers should be suggesting batteries. When a customer calls for a scheduled service, quote the price of the bare minimum OEM package to get them in the door. Don’t stuff it before you have a chance to inspect the cars for higher margin opportunities.
- Automatic stock replenishment programs typically only guarantee about 50% of the parts, while almost no dealers voluntarily do stock orders. Only Toyota, Honda, and Acura rely upon stock orders.
- When looking at an obsolete inventory, dealers may be surprised to see that a substantial portion of if consists of nonguaranteed parts. Of the dealers the consultant works with, 40% of obsolete parts being non-guaranteed is no surprise.
- The golden rule of parts used to be cost+67% to get to a 40% margin. This is no longer a good guide.
- Dealers now need to look at margin both as a number of parts in inventory as well as percent of yearly sales. OEMs have begun disrupting the margins on the high volume parts, not necessarily the parts in which you have a large stock.
- 86% of Toyota parts, by sales volume, are around 37% margin. Just low enough to make an impact at corporate, but largely unnoticeable to the average dealer.
- ASR programs generally don’t have return allowances.
- Dealers that change pricing on parts need to make sure that comp plans change along with the prices, otherwise the parts department will get an instant raise without selling one extra part.
- Months no sales vs. no receipt
- Parts can sit at 0-3 months no sale and make it seem like the parts are fresh, but there could be a ton of old parts languishing that haven’t been ordered in 12 months or longer. An extreme example to demonstrate the point would be ordering 5,000 oil filters. Sure, you’ll sell some every month, but in 2-3 years you may still have some filters from that original order.
- Use the supplier receipt date of merchandise as the basis for its stocking. This is the last receipt date.
- o Months no sale report is very misleading. Months no receipt might be misleading. A comparison and analysis of both has no chance of misleading.
- If you aren’t earning enough allowance on returns, then you should be reserving for obsolete parts.
Recruiting and Hiring
- The industry doesn’t have a recruiting problem – we have a response problem.
- The average dealership responds to internet leads within 24 hours. The average response for a job applicant is five days. As with selling a car, it’s the first to respond to the lead that gets the win.
- The average F&I manager is hired within 13.7 days, from job posting to offer.
- How long does it take you to respond to your applicants?
- How long to set up an interview?
- How long to issue an offer?
- Recruiting is a sales and marketing process.
- Today’s job seeker looks for three things:
- Pay stability
- Earning potential
- Career pathing
- Bring your brand.
- Hire the best team.
- Onboard with confidence.
- 33% of hires found their next roles within two weeks.
- 70% of applicants lose interest if they don’t hear back in one week.
- After 21 days of silence, the average applicant will not patronize the business in the future. There’s more at stake than simply filling a role.
- Within any given year, around two million job applications go unacknowledged in the industry.
- Most dealers understand customer experience. Very few dealers carry that same focus to hiring.
- Onboarding matters – sitting them in a room to watch tapes isn’t onboarding. 70% of employees that have a positive onboarding experience will remain with the company for three years, compared to a 50% turnover rate in the industry.
- Two questions to ask every applicant:
- What makes you want to work here in this role?
- What are your expectations for this role?
- Try putting the applicant into the role/environment they’re applying for. If someone says they’re good at accounts payable, then drop them at the clerk department and see how they perform. If they want to work the BDC, then tell them to make a few cold calls. They can’t fake it.
- Pricing and gross aren’t really things that sales professionals can control, but 85% of pay plans pay on gross. Nothing is more frustrating than being judged (and paid) on something outside of your control.
- Applicants that you don’t hire can still be your customers. When rejecting an applicant, be direct, be honest, be prompt, and offer something of value in exchange for their time. For example, “Thank you for showing interest in working for our company. We have already filled the role, but we would like to offer you a free oil change to show our appreciation.”
F&I Provider Dealer Agreements
The Reinsurance Agreement
- Examples of transaction fees – Ceding fee, administration fee, and premium tax paid out of reserves.
- Annual fees – Cession fee.
- Surplus relief – Amount required to be in account to handle claims. This may require dealer to make additional deposits and there could be another fee to the dealer at the time of deposit.
- Other common costs – Corporate filing fee, tax services.
Dealer Rights to Funds
- Required amount – In most cases the shareholder (dealer) can take out unearned reserves if the trust account has 115%, for example, of the required reserve amount. The excess reserves can be withdrawn.
- Loss ratio requirements – This is another requirement before excess reserves can be withdrawn (e.g. loss ratio of 90%, then dealer can withdraw).
- Capital requirement – Some capital may be required by the dealer upfront.
- Production requirements – This is a requirement to maintain certain level of vehicle service contract sales. This is often a requirement in place when a shareholder takes a loan from the reinsurance company.
- In the event of termination, do you forfeit the retro money – termination penalty? Look for this in the agreement.
- DOWC – This is a type of reinsurance company with a tax deferral structure. Under this structure, premium income is amortized over the term of the contract. In the year contract is sold, you can deduct 100% of acquisition cost. Tax deferral period is typically 3-10 years, but the contract base must keep growing to accomplish the deferral.
- Sometimes a CFC structure is better to get the small insurance company tax treatment. This structure has a $2.3mm limit.
- NCFC – This is typically utilized by larger dealer groups. This type of reinsurance company was most affected by the new tax law. To get the insurance company exemption from PFIC rules, you often need to make dividend payments every year under this structure to meet specific requirements in the code.
- Relationship between OEMS and Dealers – One current issue with some OEMs is that they are sending old product (vehicles) with the new product, but there is no change in the pricing of the old units. This causes issues with final pays on old models.
- Buy / sell market – More deals in the market, but not a lot of deals are being completed. If you are paying more than five times earnings, then you are likely servicing debt the next 10 years.
- Affordability – Foreseeing an issue with subprime markets and also with lending extensions and practices.
- CPO inventory – The Lower price alternative, but only works well when the CPO vehicles are coming from your rental fleet or trades. Going to the auction means likely lower gross: auction fees, higher price, transportation fee.
- Autonomous vehicles and electric – Developing electric infrastructure is an issue (charging stations and other infrastructure) and so is developing trained technicians. Autonomous vehicles (AV) are coming but the real need for the vehicles may be in the rental and ride sharing industry. For example, Uber is struggling with employee management and AVs could offer a better solution for ride sharing companies in the future.
- Key measurements of performance – The typical benchmarks are net income as a percent of sales, gross profit percent, and liquidity ratios. Another less commonly used measurement is free cash flow (FCF). It’s easy to look at net profit and gross, but it may not be a true indicator if the balance sheet is not properly stated (e.g. inventory is not properly valued, or proper balance sheet reserves are not in place). FCF is a good measurement tool to compensate for some unknowns.
- In a short year, use tracking wages method for purposes of calculating the W-3 wages limitation.
- 743b adjustment may impact UBIA.
- 2018 is the one opportunity to amend and aggregate business that meet certain requirements, such as ownership structure, a common management team and similar product mix.
Tax Reform: Interest Expense Limitations
- Beginning in 2022, depreciation can no longer be added back when arriving at Adjusted Taxable Income (ATI).
- The IRS could provide future guidance on related real estate entities. Many have taken the position that a related real estate entity is not a trade or business (in the case of a triple net lease) and is therefore not subject to 163(J). This is a risk, but any future changes would likely be prospective.
- Self-rental properties are not allowed to utilize the exemption as an electing real property trade or business.
- Interest expense on personal loans, where the loan is used for business purposes, can be deducted on Schedule E but is subject to 163(J).
- Depreciation recapture cannot be included in ATI – anti-double counting rule. The rule also applies to sale of stock with ordinary income from recapture.
- Proposed regulations don’t address treatment of interest in a related party loan situation. This can produce two negative tax results for individuals: (1) the interest income is taxable to the taxpayer and (2) the interest expense is subject to 163(J). However, since interest income is added back in the computation of ATI, this may not significantly impact the taxpayer.
- Some CPAs take the position that interest income from an offset account (CMA) is a reduction of interest expense. The more conservative position is you don’t net interest earned on the account with interest expense. The interest income is also subject to NIIT.
- Expecting final regulations on 163(J) by 12/31/19.
- ARC – Allied Reinsurance Co. $2.3mm max limit (small insurance company limit).
- NCFC – No small insurance company limit. PFIC rules apply.
- DOWC – Dealer Owned Warranty Co (Domestic Corporation). No small insurance company limit. Not impacted by new NOL rules.
- Retrospective Commission Agreement
- 5. Walkaway Agreement – No participation in underwriting income. Profit is only recognized by the dealer one time, at contract sale.
- Some jurisdictions require a deposit be kept on file (i.e. Florida). Deposit relieves the reinsurance company of some of the clip requirements. DOWCs originated in Florida because of these rules.
- Some structures have limitations on products that can be used. Maintenance contracts are often not seen as an insurance product and not an eligible item in 831(b). Limited warranty products are also an issue with some administrators – See related 2014 TAM.
- Sharing of risk – You may need two ARCs. You can have a quota sharing risk agreement and split the risk how you want.
- Override and spiffs – For C corps, the IRS considers overrides disguised dividends. Consider the risk of double taxation in this scenario. Also look at employee agreements and how the overrides are disclosed; the language should be clear to provide a defense in the case of litigation between employees and the company.
- Investments – Dealer is able to earn money on insurance company reserves. The change in investment return can greatly affect total projected earn-out.
- Borrowing – Generally a dealer can borrow from both earned and unearned reserves. Make sure loans perform in accordance with the agreement and funds are used for a business purpose.
- Insurance – A loss policy is a last resort. Typically, these come with high deductibles, premium tax paid in the beginning is less and the clip cost is less. A first dollar policy carries higher premium and kicks in earlier.
- Compliance – Administrators offer services for F&I as part of admin fee.
- Customer retention – Reinsurance companies can offer a mileage tieback, disappearing deductibles, etc. to incentivize business.
- Program cost – Understand what is paid to third parties out of the various fees. When evaluating various administrators, it is important to read the agreements and see what costs are actually being covered.
- Tax reform and NCFC – Prior to 2018, a reinsurance company could qualify as a foreign corporation by, for example, having 11 owners with 10% or less of vote. The tax form added 10% of the vote or value to the equation, which caused some NCFCs to look at restructuring ownership via dividend distributions to existing owners. However, some NCFCs do not have the proper provisions in their bylaws to force distributions and right the ship.
- The QEF election preserves capital gain treatment. Protective QEF elections for NCFCs gives the option to later amend and make the election if the reinsurance co structure is determined to be a PFIC.
Accounting and Assurance
- Revenue Recognition – ASC 606. Not much impact on dealer’s bottom line. It is a five step process.
- Accounting for leases – ASC 842.
- Standards update:
- SAS 134 – Changes to reporting and disclosures.
- SAS 135 – Amends sections.
- SAS 136 – EPB benefit plan audits. Term limited scope is changing.
- SAS 137 – Addresses reporting of a financial statements inside of an annual report.
- o SSARS 24 – Addresses going concern.
- State tax rates can impact multiples in a deal.
- The potential for a new point in the area can negatively impact multiples as well; estimate 30% loss in profits over three years.
- It may be in Tesla’s interest to have a dealer/franchise partner to service the Tesla fleet, repair, etc.
- Carvana now services two thirds of the US market but has a relatively low percent of market share.
- New car buyers are going to expect a Carvana model more and more, which includes delivering the car to the customer quickly and a streamlined online sales process. Also, this applies to a service department model; consider having employees that pick and drop off for the customer. This also cuts down on loaner costs. Consider using a third party to higher needed drivers.
Preparing for the Future
Maximize profit each transaction.
- Less focus on volume, more on profit per transaction.
- Improve performance in used vehicle departments, fixed operations, and F&I.
- • Less reliance on new vehicle department.
- Conduct MOR (monthly operating reviews) – Identify other key focus areas.
- Target ride sharing services. Advertising through transportation applications.
- Consider customer pickup services for parts and service.
- For key employees, consider longevity bonuses and deferred compensation plans to retain.
- Makes selling easier, less hassle.
- Speeds up time to complete deal.
- Pay plans become simpler due to less or no emphasis on gross.
- Typically, 7 months to convert dealership to one price selling.
- Monitor out-of-state sales in all departments, especially parts.
- Dealer with a large parts business (online selling) could be at risk of nexus in other states and may need to begin collecting taxes once certain thresholds have been met.
- Create separate GL accounts for:
- Meals – 50% travel
- Meals – 100% (Summer/Holiday Parties)
- Meals – Entertainment
- Review insurance captives to see if still makes sense.
- Reduction of rates and fees could make participation not beneficial.
- Separate OEM floorplan assistance and floorplan interest expense.
- Separate interest expense accounts for self-charge interest/intercompany loans.
- IRS items of interest:
- Basis schedules
- Shareholder loans
- Used vehicle write downs
- Personal expenses