M&A Due Diligence and the Power of Projections in Times of Uncertainty
By Marilou C. Vroman, CPA, CFE
As we slowly begin to emerge from the peak impacts of Coronavirus and individual states start to ease restrictions on business and personal activities, we anticipate certain dealers with cash ready to invest may take advantage of opportunities to expand their operations through strategic acquisitions. As investors entered the market in response to declining stock prices, certain dealerships may now appear increasingly attractive to potential buyers. The prospect of expansion may be especially attractive for those dealers whose operations who were able to successfully navigate the impact of COVID-19 and maintain strong balance sheets along the way. Many dealerships underperform due to leadership issues, and prospective buyers often believe they will be able to rectify these issues and improve operations upon acquisition. But in a rapidly changing and volatile environment how do we evaluate historical financial performance and sustainability of this performance going forward? How much of a financial decline was due to the Coronavirus, and how much was the responsibility of the dealer?
Valuations can be challenging even in a time of economic stability, where the buyer and the seller do not necessarily see eye to eye. However, most earnings adjustments tend to be quantifiable and can be supported. We would typically see adjustments for items such as market rent, absentee owner or family member compensation, airplanes, club memberships and other items of income or expense not anticipated to be recurring under new ownership. As we move forward however, with the financial of COVID-19 built into the financial performance of dealerships from March 2020, and beyond, approaches to dealership valuation will likely have to change. We believe more emphasis will need to be placed on utilizing projections and what it will look like to operate a dealership in “the new normal”.
Interestingly, we have seen some resilient dealers with March 2020 earnings that outperformed prior periods. However, most dealers have realized some form of operational decline. A prospective seller with these unusually favorable results may think the ability of their operations to adapt to rapid change and continue their financial success should be considered in the historical earnings.
However, each dealership has operated in a unique set of circumstances during the crisis. State and local authorities have dictated the extent to which dealerships were permitted to transact and whether auto sales and service were deemed essential businesses. For some dealers, vehicle sales were strictly prohibited while fixed operations were permitted to continue as normal. Some dealerships remained fully open with social distancing practices and rotating workforces in place, while others were closed altogether.
To counteract the adverse conditions, dealers attracted customers through incentives, discounts on repairs, and lenders offered highly attractive financing terms such as no payments for extended periods and low interest rates. At the same time, we witnessed a softening of the pre-owned vehicle market which may drive the building of aged inventories, leading to margin compression and deferred wholesale losses.
We would also have to consider whether normal operating expenses were deferred or temporarily discounted, such as advertising initiatives or payments for the DMS. Personnel may have been furloughed, laid off, or had their compensation reduced. With so many individuals seeking employment, basic economics suggest a stronger automotive talent pool may now be available at a reduced overall cost. In addition, with components of the CARES Act, we may also see additions to net income which would not be recurring.
For example, many dealers fell within the SBA small business guidelines permitting application for the Paycheck Protection Program (“PPP”) which may ultimately be deemed a “grant” if the loan proceeds are spent during the eight weeks following origination of the loan on certain payroll, rent, utilities and interest expenses. But not all dealers have, or will, receive proceeds under this program, and not all proceeds will necessarily forgivable. For those dealers who were able to secure these loans and comply with the spirit of these facilities, these loans may be fully, or in part, forgiven at a future date. The forgiveness amount will likely be recorded below the line as other income. In evaluating dealership earnings, this additional income would need to be excluded. However, the debt forgiveness amount may be reported as income in a period when dealerships have seemingly returned to “normal” operations, several months after the peak impact of COVID-19. As this income is non-recurring, and a buyer should not pay a multiple on the forgiven amount. A projection would not include these earnings.
The impacts of this pandemic can be both positive and negative.
There is still a significant amount of uncertainly in the months ahead. Arriving to a proper valuation will present itself to be more challenging than in the past. While we can simply approach the valuation by disregarding the COVID-19 period, projections will play a more significant role in determining earnings sustainability. The further in the rearview mirror the Coronavirus pandemic becomes, the more clarity we will have looking forward at earnings potential in the “new normal.”