David W. R. Harkins

After failing to qualify in 2018, the United States Men’s National Soccer Team went over 3,000 days between World Cup matches. After returning to the World Cup stage this year, the U.S. team notched draws against Wales and England, meaning that the U.S. will advance to the knockout stages if they win against Iran.In the spirit of the Cup, we compare the FIFA rankings of the world’s largest vehicle-producing countries. Spoiler alert: there is no correlation. But in our research, we found plenty of interesting nuggets. We also discuss top vehicle-producing nations that did not qualify for the World Cup and nations that did but do not have a significant presence in auto production. We also get into brand presence and Blue Sky multiples of these nations’ vehicle brands.FIFA Rankings, World Cup Groups, and Vehicle Production DataAs the industry’s supply chain issues have shown us in 2022, the world economy is interconnected. Both the World Cup and personal vehicles demonstrate a wide variety of cultures and consumer preferences. Vehicle production data in this piece is based on depressed 2022 levels reported by the International Organization of Motor Vehicle Manufacturers, or "OICA." We note this data may not perfectly illustrate nuances between manufacturing vs. assembly. For example, none of the top 10 most popular vehicle brands in Brazil in 2021 were actually Brazilian, which ranks 6th globally in population as well as car production.The table below shows all 32 countries in the World Cup that are also captured in the reported 37 largest global auto producers for 2022. Only Brazil and Spain are ranked in the top 10 of both categories, with reigning World Cup champion France producing the 12th most cars in 2022 according to OICA. Germany is also ranked highly in soccer and car production, coming in 5th in cars produced and 11th in the World FIFA Rankings.The “Group of Death”In world soccer, the "Group of Death" refers to which group looks to be the most difficult to advance to the knockout stages. With the expanded tournament and group determination based on FIFA rankings, the odds of a prohibitive favorite being in the same group as two other favorites are significantly reduced. However, the Russian invasion of Ukraine meant the last three spots had not been determined at the time of the drawing. These three spots, eventually won by Wales, Australia, and Costa Rica, were placed into Pot 4 despite their FIFA rankings. This led to Group B having teams currently ranked 5, 16, 19, and 20, or a sum of 60. The next toughest World Cup group in terms of combined FIFA ranking is Group E with Spain, Germany, Japan, and Costa Rica. In terms of vehicle production, this would certainly be the Group of Death with three of the top seven vehicle-producing countries. When you consider that China (FIFA 79) and India (FIFA 106) are two of these, that’s some heavy concentration in Group E. Group A is the only group that does not have one of the world’s largest auto-producing countries.Top Vehicle Producers That Missed Out on the World Cup Now that we have looked at World Cup participant nations’ auto production industries let’s look at nations that did not qualify. While China and India have no significant soccer history, some high-level soccer teams are also top car producers, including Russia, the Czech Republic, Slovakia, Turkey, and Italy. See the table "Other Top Car Producers" for the OICA rankings of the nations that missed out on this year’s contest in Qatar. Russia hosted the 2018 World Cup and advanced to the knockout stages but was disqualified from the 2022 tournament given the ongoing conflict with Ukraine, who failed to qualify after a 0-1 loss to Wales (which was delayed due to the war). Perhaps the biggest shock to the casual observer is the omission of Italy, who won the World Cup in 2006 and the European Championships in 2020. A poor showing in the notoriously difficult European qualifying process ended for Italy after a shocking loss to tiny North Macedonia, who went on to lose to Portugal in the playoff.World Cup Teams That Do Not Produce Many AutomobilesAs noted previously, no teams from Group A are considered top auto producers. Based on geography, each of the six World Cup confederations has at least one World Cup participant without significant auto production. Costa Rica is the only country from CONCACAF (North and Central America) omitted from the OICA list though it is a relatively short distance from Mexico. Conversely, Morocco is the only African team on the top producer list. Strictly by these rankings, both Spain (7) and Morocco (22) are equally capable of playing professional soccer and producing vehicles.Auto Brands by CountryShifting away from production, there are four countries with brands that have a significant presence in the U.S.: Japan, the U.S., Germany, and South Korea. While German vehicles are associated with luxury, Japanese vehicles are viewed as more durable. German dealerships tend to fetch higher Blue Sky multiples in the U.S., but there’s an interesting comparison with their soccer teams here. While Germany is a favored high performer, Japan is viewed as more durable. Perhaps this is how Japan came from behind in the 2-1 upset when it looked like Germany might run away with it at halftime last Wednesday.Brands by country are shown below. Other major brands in the U.S. are Jaguar/Land Rover and Volvo, which are from the U.K. and Sweden, respectively.Auto Brands by OEM and Blue SkyBelow, we’ve tabulated major brands in the U.S. market, sorted by Blue Sky value according to the Q3 Haig report. We’ve included the OEM for each brand and their home country. While Acura is Honda’s luxury brand, it was first launched in the U.S. and Canada in 1986 and is primarily based in North America today. In 1989, Toyota and Nissan responded by launching Lexus and Infiniti, respectively. Other OEMs with multiple dealerships brands in the U.S. market include:VW (Audi is a luxury offering acquired in the 1960s)GM (Cadillac is a luxury offering acquired in 1908)Hyundai (also owns Kia; neither of which are considered luxury)Ford (Lincoln is a luxury offering acquired in 1922) While Toyota has become one of the most desirable dealership brands, they are still deemed less valuable than Lexus dealerships. Audis have declined from their runup in popularity about ten years ago, but they remain considerably more valuable than their VW counterpart, who continues to climb out of its emissions scandal. While Blue Sky multiples are positively correlated to luxury brands compared to the domestic/mass market, Cadillac, Infiniti, and Lincoln are all less valuable than the mass market version offered by their OEMs. According to Haig’s Blue Sky multiples, Cadillac is below all GM brands (Chevy and Buick-GMC), Infiniti is below Nissan, and Lincoln is below Ford. Whether it’s an issue of product mix or lack of attention/investment compared to core brands, there’s a clear dichotomy in performance compared to Lexus and Audi.ConclusionWhile we would have liked to run a statistical model based on brand desirability or production, we know the correlation would be spurious at best. But that won’t stop us from cheering on the boys in red, white, and blue!Mercer Capital follows key trends in the auto industry to stay current with the operating environment of our privately held auto dealer clients. To see how prevailing trends may impact your dealership, contact a Mercer Capital professional today.

Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry.  This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own. We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1] Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.”  As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres.  That is: 640 acres per section times ¼ times ½. The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow: “To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.” This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at: 80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals.  This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved.  As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country.  Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value.  For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO

The first half of 2022 was tumultuous, which Haig Partners succinctly summarized in their Q2 Haig Report. Negative headlines and headwinds aplenty:Inflation driving up costs for dealers and reducing affordability for customersInterest rates rising also drives up dealer costs and reduces affordabilityGas prices spiked (and are receding) which also reduces affordability (though this has only indirect impact on dealer costs)The stock market (as measured by the S&P 500) is down 18.2% year to date and GDP growth has been negative for two consecutive quartersThere is geopolitical uncertainty surrounding China-Taiwan and Russia's invasion of UkraineSupply chain issues have plagued the industry for over a year and a half and consumers are well aware of the high transaction prices of vehicles Available monthly data for these economic indicators are displayed since December 2019 in the following graphs below. In spite of these conditions, dealers have navigated this environment to deliver record profits. However, Haig points to the public dealers' earnings in Q2 as an indication that dealer earnings may have plateaued. The future direction of profitability is hard to predict, but with all the historical indicators for the industry flashing red, eventually, even the supply-demand imbalance cannot overcome all of these challenges. Whenever supply starts to rebound, the key question will be the degree to which gross profitability reverts as well.Blue Sky Multiples – Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range in the next seven quarters. However, after years of only reporting a value range due to a lack of profitability, Cadillac dealerships reported at a range of 3x-4x in Q4 2021. Similarly, Infiniti and Lincoln reported a multiple range of 3x-4x in the Q2 2022. Value ranges are used instead of multiples when many of the brands' dealers are not profitable, but with improved earnings performance industry-wide, Haig is now reporting a multiple range for every brand covered in its report for the first time since at least Diesel Gate in 2014. We note the 3x-4x range for Cadillac, Infiniti, and Lincoln matches the 3x-4x range of Acura dealerships, which have consistently reported a multiple range at the low end for luxury dealerships.Blue Sky Multiples – Mid-Line Import BrandsDuring the first half of 2022, Hyundai and Kia saw another 0.25x improvement in multiple to a range of 4x-5x, building on a 0.5x improvement in Q3 2021. There are now three distinct tiers of mid-line brands: Toyota paces the top group (followed by Honda and Subaru), Hyundai and Kia, despite improvements, are still 2.0x below the top three, followed by VW, Nissan, and Mazda, which are about 1.0x below Hyundai and Kia and in line with the lowest multiples of the luxury brands.Toyota dealerships still fetch higher valuations than Audi and Jaguar-Land Rover dealerships. While they don't sell luxury vehicles, Toyotas are viewed as dependable vehicles. Potentially more important to dealers, Toyota has indicated it has no plans to replace dealerships with an agency model and is committed to a phased transition into EVs while also offering ICE vehicles and hybrids. Haig declared that Toyota might be the most desired brand in the industry. We find this interesting as Toyota dealerships remain a bargain in terms of Blue Sky's multiple range as compared to the top-of-the-line luxury dealerships. Desirability may also be factoring in cost, and the supply of luxury dealerships for sale may have an impact on the higher multiples for Porsche, Lexus, etc., particularly considering Toyota Motor Corporation owns Lexus.Blue Sky Multiples - Domestic BrandsDomestic franchise multiples have not changed since Q3 2020. With the rise of Hyundai and Kia's multiples over the past year, domestic brands' multiples are now generally in between the second and third tier of mid-line imports, where they once held a slight advantage over some of those brands. One would think that supply chain constraints would more negatively impact import brands than their domestic counterparts. However, the past two years have demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last four years, domestic brands Ford, Chevrolet and Buick-GMC are the only brands across all of the published Haig multiples that have decreased. In Q2 2018, these brands' multiples were half a turn higher than they are in Q2 2022. Stellantis actually increased over that same period but only by 0.25x.It is important to note that the published blue-sky multiple ranges, while certainly reasonable, do not imply that dealerships are actually transacting at these multiples. With the performance of most dealerships remaining elevated, owners on the lower end of Blue Sky multiples are less likely to transact when the payback period on an investment is so short unless they need liquidity or are approaching retirement without an identified succession plan.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don't directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Earnings Calls: Executive SummarySupply issues continue to dominate the industry with no end in sight. New vehicle days' supply is significantly below used vehicle supply given the numerous channels through which used vehicles can be acquired. As one would expect, supply chain issues have less impact on domestic dealerships than imports, particularly luxury.Many dealers currently have a significant number of pre-sold vehicles, which would account for either 0 or 1 days' supply if these vehicles were on the lot. While days' supply in the teens seems astronomically low, compared to 60+ days pre-COVID, the level of pre-sales some dealers are seeing, in actuality, means either there are timing issues with reporting or the vehicles that aren't pre-sold are staying on the lot much longer. For example, if a dealer has 50% pre-sold and reports 30 days' supply, that means 50 cars are sold in 0 or 1 day, and the others are sitting on the lot for two months. We find this to be an interesting dynamic and wonder if it means OEMs have yet to perfect which models to build even when prioritizing the most popular vehicles.The question was raised: what do long-term expectations look like, given that the benefits of higher prices have largely flowed to the dealers in this cycle? One analyst suggested dealers might be at peak earnings (which Group 1 said wasn't the case) and that OEMs are starting to see that maybe this is a more sustainable model for everyone. Another analyst noted that dealer margins have tripled in the past couple of years while margins of North American producers have been stable and asked why they haven't repriced some of their vehicle invoices. AutoNation's CEO Michael Manley indicated that the reduction in incentives has effectively improved the net transaction price of their vehicles. However, he conceded that OEMs facing rising costs would likely look to adjust margins going forward.We're going to go ahead and call our shot that a theme next quarter may be share buybacks. This type of capital allocation decision is not unique to auto dealers and therefore is not really an industry "theme," but we still find it notable. The recently passed Inflation Reduction Act came together after earnings were released, and each call mentioned share buybacks as an ingredient in the capital allocation strategy with no mention of the Act.Share buybacks will now be subject to a 1% tax, and it remains to be seen whether that will be enough to deter the activity. As Group 1 Automotive's CEO Earl Hesterberg said this quarter, share buybacks come with no execution risk, unlike M&A. While this opportunity is not really available to private auto dealers, both public and private dealers must figure out the best return available on the heightened profits they're receiving while the inventory shortage persists. Winners and losers will likely be separated by what investments are made before profits normalize.As valuation analysts, we like to note any mention of valuation multiples offered by the public auto dealers, which are pertinent to our private dealer clients. Lithia reiterated their valuation targets (purchase prices 15-30% of revenues, 3x-7x EBITDA, and a minimum of 15% after-tax returns). This quarter, Penske offered their views on current valuations in the marketplace, which are more in keeping with how auto dealers communicate value (in terms of Blue Sky multiples). Mr. Penske said,"If you're looking at a premium luxury, German brand, so BMW and Mercedes, Porsche, Audi you're looking at probably eight or nine times trailing 12 EBT for goodwill plus assets would be what we see. We've been able to make acquisitions for less than that where they're smaller and maybe not in the premium luxury side. Toyota and Honda are very strong. And to me, there are some people that just are going to get out of the business at the point. I think there is competition out there to buy these better points. But what's happening is many of us are running into what we call framework agreements which limit the amount of stores you can have in a particular market or with a particular brand."While this appears to be within the range of Haig's quoted multiples for these brands, it's extremely important to note that this is on trailing earnings or, as one analyst suggested on a different call, "peak" earnings. If a dealer was making $1.5 million pre-pandemic and is now making closer to $3 million, Haig's 3-year average might suggest "ongoing" earnings of $2.5 million. Applying Haig's average mid-point multiple for these four brands (approx. 8.2x), Blue Sky would be approximately $20.5 million. Taking Penske's midpoint 8.5x multiple on LTM earnings of $3 million, Blue Sky value is $25.5 million, or an increase of 24.4%.We also found it interesting that Porsche and Audi were put on the same playing field in terms of multiples, while Haig's Q1 newsletter suggested Audi was closer to 6.75x while Porsche was 9.5x.The comment on framework agreements is also perhaps a different spin on this discussion. While the public dealers have been more acquisitive lately, dealers may not want to wait too long to sell as the buyers able to pay the most may soon run out of runway to complete acquisitions unless a fundamental shift occurs in how many dealerships one company can have in a brand or market.Here are some other major themes from the Q2 2022 Public Auto Earnings Calls:Theme 1: Dealers continue to pre-sell a significant amount of their new vehicles, particularly compared to pre-pandemic pre-sales levels. With questions about an agency model, it's unclear what the long-term rate of pre-sales will look like once inventories normalize."I think the new car business is solid, but it's really hard to understand how strong it is because you have such a low days supply. Generally speaking, we're still pre-selling half the cars that are coming in. So a lot of these cars aren't getting to hit the ground. It varies a little bit by brand, but generally, that's where it is overall." – David Hult, CEO, Asbury Automotive GroupWhen you look at our domestic business, about half of our pipeline is pre-sold. When you look at our volume imports, it's 80%, some as high as 95%. And when you look at our luxuries, it's in the 60% range. And that is right where it's been for the last couple of quarters." – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive"I would say on new vehicles, about one-third of our product is pre-sold that's coming in. So that's good. And I think it's a lot of high-demand vehicles. The rest of the stuff may be wait-listed, but it's not pre-sold where we have money on the car. […] We don't have the exact data. We got it by franchise somewhere. But I would say it was close to 50% 90 days ago. So since interest rates have come up, it's definitely affected things, but it's still a robust environment where those cars hit the ground. And if someone that wants to drive the car and there's two other people waiting to drive the same car, and it's still a bit of a frenzy." – Bryan DeBoer, President and CEO, Lithia Motors"Demand is strong as we mentioned. Inventory levels are still incredibly low, high turn rates, and really sustained margins over the last few quarters. In the first quarter, from memory, I reported something like 50% of our incoming three months inventory was sold. I would say that on the domestic side, that is now down to about 35%. On imports, it is sustained, and on premium, it is also largely sustained." – Michael Manley, CEO, AutoNationTheme 2: As one might expect, the degree of unavailability when it comes to the inventory shortage depends on both make and model, with more desirable vehicles being in shorter supply. With global supply chain issues, it also makes sense that domestic vehicles are more readily available."Similar to the last few quarters, we continue to see limited new vehicle production and inventory levels due to supply chain disruptions and strong consumer demand for new vehicles. This contributed to a 33% decrease in same-store retail new vehicle unit sales volume higher than the industry retail SAAR decline of 20% due to our luxury and import weighted brand mix, which continues to have lower days' supply of inventory than domestic brands"– David Smith, CEO, Sonic Automotive"Our domestic days' supply on new is around 60 days. So we have pretty good flow even though there's some in-transit on that. Really our softness in days' supply, which is where we really are selling every car that we get about as quick as we can get them is in our imports, which we're sitting at a 16-day supply and our luxuries are sitting at about a 29-day supply."– Bryan DeBoer, President and CEO, Lithia Motors"We have a 21-day supply of new vehicles with premium at 23, volume foreign at 8, and domestic at 21. New vehicle supply is at 12 days in the U.S. and 32 days in the U.K. We continue to sell into our future new vehicle pipeline to support tour customers, maximize inventory turn and minimize our inventory costs."– Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 3: Continuing a theme from last quarter, analysts asked if executives were seeing signs of a struggling consumer. They also wondered if banks were being tighter with credit, given macro headwinds and inflated vehicle prices, though the public auto dealers generally downplayed concerns. When Penske was asked about entering the captive finance space, their response indicated a level of concern about the strength of the consumer. An analyst offered that there was a tiny sequential erosion in the strength of the consumer, but it was still strong relative to pre-pandemic and relative to supply which AutoNation agreed with."With consumers financially healthy, consumer financing readily available, the car park aged to record levels and sizable pent up demand combined with our technology to improve efficiency and productivity, we are well-positioned to weather the current market conditions. […] I would say people were impulsively buying six months ago. They're probably putting a little bit more thought and care into the selection and the pricing right now."– David Hult, CEO, Asbury Automotive Group"We're seeing no tightening whatsoever. When you think about the asset class performed very well in 2008 and '09. And when I talked to the head of these finance companies, as I said, they're seeing some delinquency increase on the lower end but its back to pre-COVID levels. But I think the reassuring part of that is losses are historic lows and the appetite for car loans is robust. So, we have not lost any car business because of the availability of credit."– Peter DeLongchamps, SVP, Manufacturer Relations, Financial Services and Public Affairs, Group 1 AutomotiveThe demand is there, but the demand is not there for a $640 monthly payment for preowned that's what you're getting and you're selling a 1- to 4- year car right now at $30,000 to $31,000. And so retooling to the 5-year-old plus cars, we're able to get that monthly payment back down into the $400 range, which is historically where it needs to be. So, consumers are buying a little higher amount car at a lower payment. And we've been able to continue to keep our warranty penetration up there. So not concerned at all about preowned demand."– Jeff Dyke, President, Sonic Automotive"Today with delinquencies going up on retail across all other markets, I wonder -- and then you're going to blow up your balance sheet. And on top of that you're going to have to take that and sell it into the market and securitize it. And I think today, the people that buy that are going to say is this really what we want to buy 72-month or 60-month paper from the standpoint in the car business with the inflation that we've had on used car prices? So not that we won't ever get into it, but we think it's a bad idea. Right now, we don't think that glove fits our hand."– Roger Penske, Chairman & CEO, Penske Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Lately, Carvana has been in the news for all the wrong reasons.Its share price is down over 90% since its pandemic peak and currently sits below the low levels of March 2020.This post provides an abbreviated history of Carvana from its founding in 2012 to 2022 and discusses what its successes and struggles mean for traditional auto dealerships.Where It All beganThe company was founded by Ernie Garcia III in 2012. Garcia sought to improve the vehicle buying experience for consumers. He attributed the idea partly to how cars are bought and sold at wholesale auctions. These auctions are key sources of supply for auto dealers, particularly used vehicle dealers with limited opportunities to acquire cars via trade-ins. Garcia noted it took dealers all of 30 seconds of seeing a vehicle to purchase it. His vision was to bring this ease of acquisition mainstream.Prior to founding Carvana, Garcia began working at DriveTime Automotive Group in 2007, an auto giant owned by his father. This is where he got the idea of selling cars online, though it would take years for this idea to take off.What Makes Carvana UniqueCarvana has become known for its iconic car vending machines which debuted in late 2015. These worked as a centralized location for customers to pick up vehicles, lowering delivery costs. It was also a novel concept with marketing benefits for the brand. Compared to a traditional dealership, going vertical reduced the upfront investment in real estate compared to large, expansive lots that are largely sitting empty in the current inventory shortage.Another thing that makes Carvana stand out is its online-first presence. Carvana operates as an online platform to buy and sell used cars, but this option for consumers isn't new. The difference with Carvana is that the company acts as the dealership rather than taking a fee for simply listing the vehicles. The company also earns a substantial amount of its gross profit from financing rather than the actual sale of vehicles. Vehicle financing has increasingly become a key aspect of profitability for traditional dealerships as well.While Carvana fixes the vehicles it purchases prior to reselling them, they don't provide after-sale services like repair and maintenance, a key driver of profitability for traditional dealerships.Scaling the BusinessCarvana seeks to provide a uniform buying experience with price transparency, an oft-cited pain point with traditional auto sales for consumers. To achieve this, the company needed to significantly increase scale in order to be profitable.A few years after its founding, the company struggled to gain traction. It resorted to two tactics instrumental to the company's success. First, it subsidized consumers by selling vehicles at or sometimes below cost. This, of course, raised the company's sales from a volume perspective and contributed to significant growth. The company has for years sold a growth story like many other online companies. The thought process is that it can increase its prices once it achieves sufficient scale using its aggressive pricing strategy.Carvana's strategy was to use its aggressive pricing (selling cars at or below cost) to create scale. From there they could increase prices and reach profitability.Carvana's second tactic was listing its inventory in numerous markets. While it had fewer cars to sell than its competitors, it began using virtual addresses in order to appear to have a presence in more markets than it actually did. Consumers surveying their options might go into a dealership if they know the brand they want but aren't sure about the model. Before Carvana, third-party listing sites were a better way to start the research process for consumers that were brand-agnostic.Carvana's strategy enabled its vehicles to show up in more markets, and they subsidized the cost of shipping the vehicle once a sale was recorded. While this strategy was not sustainable from a profit perspective, the investment paid off and generated significant traction. The company's IPO in 2017 further increased its visibility, and its growth story and positioning as a "disruptor" captured public attention in an industry with room for improvement in the customer experience.Flying Too Close to the SunThe company rode its growth story to a stock price of $110 in February 2020. In less than a month, concerns around the COVID-19 pandemic led the stock price to decline 73% to $29. Less than a week later, the stock was back to $63 as the market, at large, sought to reprice all stocks based on uncertain expectations of the path forward.By June 2020, the stock peaked again as the company was viewed as an early "winner" from the pandemic. Auto sales plummeted in March and April 2020 as dealers were thrust into the world of online sales as a means of survival. For Carvana, the forced shift to online played directly to their strengths.Prior to the pandemic, the online market for purchasing vehicles was presumed to be relatively small. While online retail works great for certain products, large purchases like cars and mattresses were supposed to be impervious to the "Amazon-ification" of retail. There were two main reasons for this thesis: life cycle of the purchase and cost.It has long been held that consumers spending large sums of money on products they intend to use for years want to touch and feel what they're buying to ensure they like it. The last thing you want to do is get a bad night's sleep on a bed the first night after you've just shelled out $100s of dollars for a new mattress. The same can be said for the style and feel of automobiles, which is why dealers keep so much inventory on the lots for consumers to test drive various options.Consumer financing for cars can also be difficult to complete online. Having a dealer walk people through their options or direct them to more affordable options is beneficial to the dealer who still gets the sale and the consumer that needs help wading through the financing process. Carvana appeared to solve both of these problems with easy-to-use online financing tools and a 7-day test drive period. This was a plus compared to the traditional ~30 minutes a consumer spends with a vehicle prior to purchasing it from a dealership.Before the end of 2020, it was clear that auto dealers (both traditional and online) were benefiting from the economic environment caused by the pandemic as sales bounced back and an increased reliance on technology and lower headcount, interest rates, and advertising led to lower costs. As the pandemic continued, auto dealerships saw heightened profitability, and Carvana's stock price soared to a high of $370 in August 2021. Conditions were so strong that the growth-focused Carvana actually reported positive earnings per share in Q2 2021. This appeared as though it could be the turning point for the company. Maybe it was reaching the necessary scale to generate large profits in the future.Unfortunately, the wind has been taken out of its sales as the macro environment has changed in 2022 with rising interest rates and now fears of a recession. At $25 as of last Friday (July 22, 2022), the stock now sits lower than it did in the depths of the pandemic and is closer to where it traded in the first half of 2018. It's fair to raise the question: "If the company couldn't make money in the most ideal of conditions for auto dealers (in addition to forced adoption of online retail), what is its ultimate path to sustained profitability?" While the company's innovative ideas generated plenty of traction with consumers, they did not lead to a moat for its operations. Stated plainly, other companies can copy Carvana's offerings, reducing or removing all of its competitive advantages from being the first-mover.Recent StrugglesMatching stock price declines, headlines about Carvana are becoming increasingly negative as its fairy tale ride may be coming to an end. Recently, the company has announced layoffs in order to preserve cash. However, a smaller staff may only exacerbate the back-end paperwork issues the company is currently facing. While the company downplays the pervasiveness of the issue, an article in Barron's (subscription may be required) chronicles consumers' struggles with registration delays and issuance of multiple temporary license plates from various states enabling it to sell vehicles for which it had not yet received the title. In many states in which the company does business, such sales are illegal. For these consumers, the relative ease of front-end purchase as compared to in-store dealerships may not be worth the back-end headaches as Carvana seeks to straighten out these issues. Long-term, Carvana is selling a better customer experience, which will extend beyond the initial purchase by getting all the necessary paperwork completed to be street legal.Anecdotally, we had a colleague last week who spent the better part of a day at the DMV attempting to get his car registered after temporary plates could no longer be extended by law. While the DMV may have shared in some of the blame in this situation, he has yet to receive a title four months after purchase. Interestingly, there were about ten other people at the DMV with similar Carvana issues, though many of them were happy, loyal customers that raved about the front-end experience despite the back-end frustrations.Carvana's core profitability lever (financing) is seeing demand cool.In addition to back-end issues, the company's core profitability lever (financing) is seeing demand cool. While Carvana is well-known for its vending machines and no-haggle pricing on its website, its earnings (or lack thereof) are more dependent on its financing. Instead of marking up the vehicles, it sells to market levels, the company subsidizes lower purchase prices to scale and also makes money on the auto loans it originates. Rather than holding these on its balance sheet, the company packages or "securitizes" these loans and sells them to investors.With near-zero interest rates and a strong economic environment, there was plenty of demand for the increased yield offered on these loans. However, with concerns about the financial strength of consumers and rising interest rates, there is less demand for the loans generated by Carvana. In the second quarter, Carvana didn't sell a pool of non-prime loans. In previous quarters, it had securitized both prime and non-prime loans. The company is due to report "earnings" on August 4, and some analysts are pessimistic.Takeaways for Auto DealersDespite its issues, Carvana is the poster child for many consumer-centric shifts in the car buying space.Consumers across the country now have numerous options to buy vehicles online, with extended test drive options becoming more available. Carvana's decentralized approach and lower investment in real estate may also change the level of investment needed for the dealership of the future, though one could argue the current inventory shortage situation may have pushed the industry in this direction even without Carvana.The auto dealer industry will continue to rely on and require investments in technology, particularly technology centered around the online buying experience. Dealers unwilling or unable to make these investments may opt to divest their dealership while profits and values are at relative peaks.The fortunate thing for dealers is their access to new and used vehicles, in addition to financing and servicing of vehicles, ultimately means there are numerous potential profit centers that provide downside protection through all economic cycles. Online retailers like Carvana are seeking to disrupt the industry, but their lack of new vehicles and service departments put them at a distinct disadvantage that even explosive growth may not be able to overcome.Mercer Capital follows the key players in the auto industry in order to stay current with the operating environment of our privately held auto dealer clients. To see how these trends may impact your dealership, contact a Mercer Capital professional today.

There continues to be no end in sight for new vehicle supply constraints. So much so that it's taken as a given, and there was less direct mention of inventory shortages in 2022's first quarter public auto dealer earnings calls. Despite this shift, scarce inventory remains the key theme underpinning the operating environment for auto dealers.Demand continues to exceed supply across all OEMs. For example, Lithia Motors noted it started a month with 13,000 vehicles and ended with 12,000 vehicles but was still able to sell over 24,000 vehicles. We've seen this with our auto dealer clients, and it really brings into focus what Days' Supply consistently under 30 looks like. When dealers are selling nearly double the inventory on their lots, it will take a long time before inventories can build back to pre-COVID levels. And with higher profits for dealers and OEMs, we may not ever reapproach those levels.Even more so than last quarter, there are a couple of interesting nuggets that don't quite fall into themes that were noteworthy. For example, much has been made about the future of electric vehicles and the impact on auto dealers. There have been concerns about a shift towards an agency model and conventional wisdom has been that EVs would generate less service work for dealers. Asbury's VP, Dan Clara, challenged that notion this quarter with the following:"My belief is the propensity or the frequency of [EVs] coming to the shop will be less. But the time in dollars will be greater, not just what they spend, but what we end up charging because of sophistication to work at it. And putting electric aside and not talking about autonomous, there are some technology features in cars today, braking where your car can break with someone in front of you, lane changing, the shifting and learning you. That's all technology that could have bugs in them. So while the cars really get heavy content with technology, not just the battery piece, it allows for more opportunity for things to go wrong. And when you talk about driving a 5,000-pound vehicle at 60 miles an hour down the road, there's a lot of liability in touching those cars. So you've really got to be thoughtful and think about what you're going to do over the [airwaves] that are nice to have and what you're going to do that may have a real liability issue in driving the vehicle."So, while he acknowledges there may be fewer ROs, dealers stand to potentially increase their pricing power for more complex work while also taking market share from less sophisticated body shops. As we've noted before, a significant amount of repair work is not performed by auto dealers at present, which provides an opportunity if the shift in powertrain steers more consumers back to the dealership. Fixed operations have generally improved as vehicle miles traveled increase and people continue to return to the roads. However, a depressed SAAR since 2020 has held back warranty work for many public auto dealers.While the themes presented below touch on M&A and large auto groups seeking to manage their investment in dealerships as a portfolio, Roger Penske discussed the benefits of open point locations, which are amplified in this low inventory environment:"On an open point, they have a plan that says this is the planning potential for a point, let's say, it's 1,500. And what they will do is preload you with those cars when you-- before you open and you get those for about, I think, probably about 90 to maybe 180 days, but then you're on a run rate based on your history. So it works out well. And I think -- after spending $15 million or $20 million on a facility, you certainly need the cars to start the business. I think it's certainly good for future allocation because you continue to meet the requirements of the planning potential and to give you the cars or trucks to be able to meet that early on. So it's up to you to drive it, and then maintain it."Here are the major themes from the Q1 2022 Public Auto Earnings Calls:Theme 1: CarMax kicked off earnings season by attributing a decline in its used car volumes to affordability issues. Affordability became a common question of the franchised dealerships due to this statement, particularly as interest rates rise. While Penske acknowledged that affordability likely had some impact, other companies tended to downplay any concerns."Inflation is never good for the consumer, but clearly, it's going to hit the lower demographic sectors of the market first. And there is such a massive gap and has been such a massive gap for the last 18 months between supply and demand. But first of all, demand would have to come down on new vehicles a long way before it got anywhere close to supply. […] And our core customers, while it may be not ideal, we just don't have data that shows that that we're seeing less activity in our stores yet." – Earl Hesterberg, President and CEO, Group 1 Automotive"What we're seeing from a macro perspective is there's not any material impact to the prime and near prime consumers. Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, that you're starting to see a little bit on the lower income, but on the upper tier that we're not seeing anything material." – Heath Byrd, CFO, Sonic Automotive"And then, there is some affordability issues there which are going to have some impact on margin. But from an overall standpoint, the demand is strong, we're selling into our pipeline from the standpoint of our new car business, and sequentially in our units are up from 101,000 to 114,000. If you look at Q4 to Q1, so we're not seeing it at the moment that we're having any impact negatively at this point. – Roger Penske, Chairman & CEO, Penske Automotive Group"The demand is there. I'd disagree with the comment made a few weeks ago. I don't think that's accurate. There's still plenty of demand. There'll be 37 million to 40 million cars sold in America this year in terms of pre-owned. So, the demand is there. The problem is, is that we're pushing $500 a month payments, and we used to pay $400 a month payments, and it's too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it's always run 50% to 55%, somewhere in there. It's at 70%. It's too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That's just not -- that's out of the norm and that's what's causing someone to maybe think that there's not a demand there. – Jeff Dyke, President, Sonic AutomotiveTheme 2: With the backdrop of framework agreements, large public auto groups are managing their stores as a portfolio, seeking to optimize by brand and geography. When certain OEMs only allow a certain number of stores per auto group, they are more selective about the markets in which they choose to operate their finite number of dealerships."We'll continue to monitor the M&A market as we believe there are potential opportunities that would enhance our already strong dealership portfolio. […] We have the ability through relationships today to go out and purchase another $5 billion if we wanted to today. Our goal is not to grow quickly. Our goal is to grow thoughtfully and be great capital allocators for our shareholders. So I think that the timing, cadence and pace is important. I think the states where you've seen us grow in our thought process of balancing the brands with the right states, you won't see us differ from that and acquisitions going forward will be accretive for us. The one thing I don't think our space gets a lot of look at is portfolio management. What do they buy? What do they sell? What did that do from an accretion standpoint? Not from a top line revenue, but what did that really do to them as a whole? And so I think you'll see us really manage the portfolio well. You'll see more divestitures over time, probably at some point in the future. And you'll certainly see more acquisitions as well. But that's just really maximizing the portfolio to generate the highest returns and create the most stable company for our employees and our shareholders." – David Hult, CEO, Asbury Automotive Group"I think most importantly, we always optimize our network to make sure that it's clean. We bought stores over the years that, that were in groups typically that weren't right for Lithia and it's a matter of divesting those. I believe it was annual run rate of about $90 million were sold in the quarter. And a number of those were assets that we just don't believe were to some extent salable okay and in this environment, everything is kind of salable. So we took advantage of that and divest of those stores. And you'll see, you'll probably see more of that in the next few quarters. You probably have a half a dozen stores that are typically smaller stores may be located in an area where it's not helping our network at all, meaning, it's a duplicate store, secondary store or it's into smaller market where you're utilizing a General Manager talent and you can reposition them in a better and bigger store." – Bryan DeBoer, President and CEO, Lithia Motors"We signed up for framework agreements probably, what, 10 year sago, there were some with some like Honda, Lexus had it, and we've lived with those over time. Now they are getting more active now when you look at BMW and other of these manufacturers are coming in now with probably not as much to try to curtail the growth but more to be sure that the dealerships that you already have are meeting the CSI requirements, and the CI and the market performance. And that's what they're looking at before they would allow you to grow. […] I don't think they're saying no. In fact, if you're a good dealer, and you've got a good track record, they [only] limit you to [a] number in a particular market, so you're not the only dealer in the marketplace. I think other than that, they're very appreciative when we come to them with an opportunity because they know we've got the capital, we've got a track record. We've got a management team that many of them know. And I've seen you've seen the growth just in the public, and they've been approved with big acquisitions. Now in some cases, you might have a market where you have to sell something off. But I think that is easy. I mean we made a move from Lexus in New Jersey to buying the two Lexus stores in Austin, and we had to divest the two to get two more. But obviously, I looked at the Jersey market versus the Austin market, and feel, on a longer-term basis, it would be a better opportunity for the Company." – Roger Penske, Chairman & CEO, Penske Automotive Group"We're in a cyclical business, right? So obviously for me I like the blend that we have in terms of brands. I think it's a really good blend particularly when I think through the plan for the individual OEMs are put in place, because ultimately the product that they are working on today really is going to dictate the success on the new car side of the business going forward. Firstly, I am encouraged by the level of investment has been made. And secondly, it doesn't really change my view on the balance that we have in our portfolio today. I think it just reinforces we have a good balance. – Michael Manley, CEO, AutoNation"It's a timing situation. We were competing to buy LHM. We didn't know who we're competing against and didn't know we were getting the deal. The Stevinson deal […] came together quick. We didn't want to pass on that opportunity not knowing if we're going to get the Miller organization. Then fast forward, we signed Stevinson and then we got the Miller one. So we knew we had an issue because the manufacturer has a limit to how many stores you can own and reach in. So we knew that we would have to sell some stores." – David Hult, CEO, Asbury Automotive GroupTheme 3: The franchise dealer model is alive and well. Multiple companies emphasized vehicle acquisition as the key to performance in used vehicles, and a primary driver is trade-ins when customers purchase new vehicles."We continue to focus on the acquisition of the inventory. We all know that is in used cars, where the return is generated. Close to 85%, 86% of our acquisition is coming through the consumer, whether it is in the form of our leased earnings, trades or buying cars through -- directly from the consumers." – Daniel Clara, SVP and CFO, Asbury Automotive Group"As we all know, success in the used car market is dictated by your ability to manufacture great quality, well priced desirable used cars and this clearly covers key elements of the business, including efficient and effective reconditioning for example, but it all starts fundamentally with your ability to competitively acquire used inventory and with strong consumer demand we continue to focus on our self-sourcing capabilities for used vehicles, which I think further strengthened both our franchise dealerships but also our AutoNation USA businesses." – Michael Manley, CEO, AutoNation"We're a different business than CarMax or Carvana and some of these used car retailers. Because, number one, we've got a large parts and service business, which covers 60% to 70% of our fixed costs. We also have OEMs that we're tied to would give us an area of market that we operate in. And they provide us with all the umbrella advertising to drive customers, both new and used to our stores, and then we have the relationship with the captive finance companies. And then, the lease returns that are coming in give us in the future when the cars are available for additional use. So looking at that, taking that as really a base to work from, we've got a short supply of new cars, which is driving used car prices up. And certainly, our acquisitions have been very tough at the moment when you think of about just looking at CarShop in the U.S., in the UK and the U.S. are our cost of sales up $8,500 [per unit] and the UK is up [$4,400 per unit]. And when you add that on to the existing number, it's really pricing us on the U.S. side, up into almost new car numbers." – Roger Penske, Chairman & CEO, Penske Automotive Group"As a top of funnel, new car dealer that gets to used vehicles coming in on-trade. We're making about $1,900 more on vehicles that come in from consumers than that we buy at auctions or from other dealers and we turn that much faster. So it's a huge advantage that we have […] a pipeline of inventory coming in quickly on the used car side." – Chris Holzshu, EVP & COO and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Pre-COVID and chip shortage, it would be no surprise if Blue Sky multiples remained stable over numerous quarters for many brands. As seen in the charts later in this post, multiples normally don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM.In 2020, the economic shock to the economy borne by the COVID-19 pandemic caused Blue Sky multiples to oscillate in near lockstep, regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples. As the chip shortage and lack of inventory have persisted into 2022, auto dealers are getting more credit for recent outperformance as earnings rise steadily.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the following year. Since the onset of the pandemic, as expectations have been much more dynamic, the earnings stream to determine ongoing expectations has shifted.Throughout most of 2020, Haig’s Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any negative COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Throughout the latter half of 2020, it became clear that the pandemic positively impacted earnings. Most dealers significantly outpaced pre-COVID results, despite a month or two of nearly stand-still operations.In late 2020 and into 2021, Haig reports that buyers were using a three-year average of adjusted profits from 2018, 2019, and LTM ’20 or ’21, or two years of pre-pandemic results and one year of outperformance. The prevailing thought was that the outperformance due to COVID would eventually normalize, and buyers didn’t want to overpay for dealerships that may not be able to repeat these earnings in the future.Now in 2022, Haig reports that buyers are ready to acknowledge that not only have earnings continuously increased, but the inventory shortages show no signs of abating. As we’ve noted for months, industry players have continuously said the situation should normalize in the next 6-9 months. But they’ve been saying that since about February 2021, or 14 months ago.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up.As we sit here today, the outlook is still uncertain, but I personally wouldn’t have extreme confidence to say operating conditions or earnings will normalize in 2022. The lead time to meaningfully increase microchip production is clearly long, and with record profits for dealers and manufacturers, OEMs aren’t necessarily incentivized to change the status quo. Demand for personal vehicles is certainly more inelastic than the market previously indicated.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up. With earnings steadily increasing, Blue Sky values have followed the same path. That’s why it’s important to understand what level of earnings are being applied to the multiple.Illustrative Example: HondaTo show the path of Blue Sky values since the onset of the pandemic, we’re going to take pre-tax earnings for average import dealerships as reported by NADA and apply them to the appropriate multiple. Last year, we did this analysis for Lexus, so we’re switching from Luxury to Mid-Line Import. We also thought earnings would normalize, yet it has gone the opposite direction in the past year. Unfortunately, due to licensing issues, NADA no longer posts monthly dealer financial data on its website, so our analysis is only based on what we had previously saved, and we must use some extrapolations.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 5.5x to 6.5x for Honda dealerships (tied with Toyota for the highest multiple for import dealerships). With 2019 pre-tax earnings of $1.66 million for the average import dealership, the implied Blue Sky value for the average Honda franchise would range between $9.1 million and $10.8 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $8.3 million to $9.9 million.By year-end 2020, multiples and earnings each increased significantly, and Honda was up to a range of 6x-7x, or $11.1 million to $12.9 million based on a 3-year average pre-tax earnings of $1.84 million. Through a tumultuous year, the multiple landed a half-turn higher than Q4 2019, and earnings were up 39.9%. Even using the 3-year average, “ongoing” earnings at year-end 2020 were up 11.2% from 2019. As seen on the chart above, Honda’s reported Blue Sky multiples have been unchanged since Q3 2020 at a range of 6x-7x. But from Q3 2020 to Q3 2021, earnings more than doubled, and 3-year average earnings increased 51% from $1.67 million to $2.52 million. Multiplying by the mid-point of the range, Blue Sky values increased from $10.9 million to $16.4 million. In Haig’s Q4 2021 report, ongoing earnings are now expected to be based on 2019, 2020, and 2021 earnings. With 2021 performance more than double 2018 earnings for import dealerships, this change in methodology further increases ongoing earnings. Based on our estimate of 2021 earnings, the average Honda dealership would fetch $18.6 million in Blue Sky or double its value from Q1 2020. While the mid-point multiple has only increased from 5.5x to 6.5x, ongoing earnings increased from $1.66 million to $2.86 million.Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership.We consider a hypothetical transaction to further illustrate how Blue Sky values have exploded. If a Honda dealership was sold in January 2021 at the prevailing mid-point Blue Sky multiple of 6.5x applied to 3-year average earnings of 2018, 2019, and 2020, the seller would’ve received just under $12.0 million in Blue Sky. The buyer’s first year of earnings in 2021 would be an estimated $4.44 million, way above the “ongoing” expectation. While nobody expects 2021 performance to be earnings into perpetuity, the implied Blue Sky multiple of that transaction was only 2.7x, or lower than any reported Blue Sky multiple range. While few could predict what would happen in 2021, the hypothetical buyer above was a clear winner. While there are numerous doomsday scenarios for dealers these days about longer-term perspectives, I would think twice before selling my largest investment while at peak cash flows that I felt I had some control over if I wasn’t getting well compensated. Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership. Below, we observe how Blue Sky multiples have changed over the past five years. However, as we’ve illustrated above, the recent lack of movement is not indicative of stagnant Blue Sky values.Blue Sky Multiples: Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range, though as highlighted above with imports, dealership values have taken off. After years of only reporting a value range due to a lack of profitability, Cadillac dealerships are now reported at a range of 3x-4x and will be included in future graphs. This multiple range is in line with Acura as the lowest for luxury dealerships. Despite being luxury brands, 3-4x is the lowest reported multiple range, in line with VW and Mazda, which have had their fair share of struggles in recent years.Blue Sky Multiples: Mid-Line Import BrandsFour of the eight Mid-Line Imports multiples improved in the second half of 2021. In Q3 2021, Kia and Hyundai multiples increased 0.5x to 3.75x-4.75x, further distancing these dealerships from the lower half of the mid-line imports (VW, Mazda, and Nissan) though as seen in the graph below, still well below Toyota, Honda, and Subaru. Nissan’s multiple also ticked up 0.25x in Q3 2021, making it slightly more desirable than VW and Mazda.Toyota was the only brand to see a change in its multiple in Q4 2021, modestly increasing its lead at the top of the group at 6.5x-7.5x. Toyota dealerships now fetch just higher valuations than Audi and Jaguar-Land Rover dealerships. While they don’t sell luxury vehicles, Toyotas are definitely viewed as dependable vehicles which consumers can appreciate. Toyota has also taken a balanced approach in terms of EV adoption, which makes sense for the company that really pioneered the hybrid approach with its Prius in the early 2000’s.Blue Sky Multiples: Domestic BrandsDomestic franchise multiples have not changed in the past year, all generally above the lackluster mid-line imports but well below other players. One would think that supply chain constraints would negatively impact import brands more than their domestic counterparts. However, the past year has demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last five years, Stellantis dealerships have seen their multiples modestly improve, while Ford, Chevy, and Buick-GMC are all down. Only Audi shows a decline in the past five years while Acura, Honda, and Mazda are unchanged and everyone else has seen their multiples increase. While domestic dealerships have not received high Blue Sky multiples, they have been well positioned for the shift from cars to trucks, and heightened earnings across the board is likely to lead to greater return on investment for dealerships that trade at lower multiples.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple. If a dealer feels they are being reasonably compensated, they may choose to sell. As demonstrated in this post, earnings expectations can be significantly different from actual results.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key value drivers. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

There continues to be no end in sight for new vehicle supply constraints. In past posts we have noted how executives keep kicking the can down the road, guessing things will normalize in 6 months or so, which they’ve been saying for the past twelve months. Group 1’s management team was refreshingly honest on the situation as detailed in the quote below.“I have been unable to predict on [when inventories normalize] with any accuracy at all. I continue to be shocked. And every month seems to delay the recovery another month. Clearly, no one is building inventory still. […] It seems that there are some issues beyond chips as well now with COVID interruptions and shipping interruptions […] I can’t even keep track of all the stated reasons. But it would certainly seem the first half of the year is going to remain with severe new vehicle inventory shortages. I don’t know what will happen in the second half of the year.” – Earl Hesterberg, CEO of Group 1 AutomotiveInventory shortages are at the forefront of many of this quarter’s themes. While dealers across the country are looking to increase their new vehicle inventories, used vehicles are in greater supply. Numerous executives noted they are carefully managing this inventory to avoid getting burned on currently elevated prices. All the publics (except Lithia) explicitly mentioned a hope that inventories would increase to a new normal, that is below pre-pandemic inventory levels. Executives also seem to generally believe that GPUs will normalize with inventories, though a push for market share by industry participants may further shrink GPUs once inventory is available.On February 15, Edmunds released research indicating 82% of car shoppers paid above sticker price in January. While there have been reports of dealers charging above the manufacturer’s suggested retail price (“MSRP”) since mid-2021, the practice has proliferated and analysts sought comment on the topic this quarter, which was generally denounced for various reasons, again with Lithia being the exception.M&A was not as big of a topic of conversation as in prior calls, though it does still come up. The current M&A market for dealerships is similar to the market for the vehicles they sell: values are elevated above historical norms. As a result, dealer principals may be more interested in testing the waters on what they could get for their dealership. Most executives and dealer principals acknowledge that recent strength in new vehicle grosses should normalize whenever inventories normalize (we’re still waiting). Still, if dealers think the price is right, they may be willing to sell if they can get anywhere near a “normal” multiple on these heightened profits.Private dealers testing the waters on the Blue Sky for their dealership reminds me of Zillow’s “Make Me Move” feature that they recently discontinued. Homeowners on the fence about selling used to be able to post a high price, and if they got traction, they may decide to sell, avoiding the potential penalty of having your home listed for a significant amount of time, which leads to price concessions or actually discourages would-be buyers assuming something “must be wrong” with the house. Bringing it back to vehicles, I recently tested what offer I’d get on my 11-year old vehicle and was pleasantly surprised as it was considerably above its pre-pandemic value.When it comes to M&A for the public automotive retailers, they continue to focus on brand and geographic fit. An interesting nugget came from Sonic that may be interesting to smaller market dealers. While 2021 was the year of the mega-deal, Sonic noted its large RFJ acquisition (which was one of the mega-deals) primarily operates in smaller markets. While the company previously would not have been interested in buying such dealerships, the success they’ve seen thus far means they are open to more tuck-in acquisitions of dealerships in smaller markets, a welcome development for such dealer principals.A couple of other interesting pieces didn’t quite make their own theme. Penske threw cold water on the adoption of EVs, noting that 98% of its sales have been ICE over the past three years, and while OEMs have committed to more EV models, Penske believes it will take “longer than people expect” for widespread adoption, largely due to costs of EVs. Regarding discussions about direct-to-consumer sales, he also called attention paid to startups like Rivian “overblown.” Penske also holds more used vehicle inventory than Asbury, AutoNation, Group 1, and Sonic.Lithia also holds more used vehicle inventories than its peers and as noted previously, and doesn’t have a problem with charging over MSRP. Curiously, its executives also began positioning the company for an environment without franchise laws as it suggests the industry could move towards an agency model with its manufacturers by 2035 (see page 18 of its investor presentation).Theme 1: While dealers are looking forward to more normal inventory levels, they believe there is something to be learned from the heightened profits in the last year: auto dealers are hoping “normalized” inventory levels will be considerably below pre-pandemic levels.“So we don't want 60-day supply inventory. We don't need more 45-day supply inventory. They could just get it back to the 20 and 30-day supply you got great demand, great margin, and it sets up '22 and really '23 for just to be fantastic years for the industry. – David Smith, CEO, Sonic Automotive“The OEMs have become more sophisticated in that regard. And they understand that too much inventory is bad for us and we're not going to take it. And it's bad for them too. And that lesson is really being driven home right now to the OEMs as to the cost of excess inventory. The distribution channels in both the US and UK have been overstuffed for a decade or more. And now that they get leaned out, you can see what it does for the OEM profits also. It's much better for them. And so I think we're going to be in a much better position going forward.” –Earl Hesterberg, President and CEO, Group 1 Automotive“I have to believe that given all the learning through the pandemic and supply and demand dynamics that we've recently seen and the clear messages coming from the manufacturers, we will not return to the excessively high inventory levels that depressed new vehicle margins for both the dealers and the OEMs. […] And the levels of profitability for both OEMs and dealers clearly show the benefits of selling vehicles at MSRP. And what a concept, right, selling at MSRP.” –Michael Manley, CEO, AutoNation“When you look at the floor plan support, you look at customer support, and you look at the incentives that are being paid over the traditional years where we had normal business, the OEMs are digging deep in their pocket. Now they’ve seen a real benefit by backing that off. In fact, I think that’s helping them look rationally down the road that will help them find the R&D that’s going to be necessary when we look at electrification. So hopefully, they got a taste of that. And that will be a slow return and they’ll keep the day supply in the 30 to 45 days and we won’t obviously be where we are today in single-digits. But I think we can manage that carefully brand by brand.” –Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 2: Whenever vehicle inventories normalize, vehicle profitability is expected to normalize as well, though some executives cautioned an attempt to grab market share could further depress heightened GPUs. Notably, Lithia’s base case assumes vehicle profitability fully returns to pre-pandemic levels.“Well, I would hope no one would ever go over 50 days again. And, of course, historically the domestic has always had well over that because of these -- the big variation on the build combinations of full-size trucks and things like that. But for decades Toyota dealers have operated well below 30 days and never missed that much business as far as I could tell. So I think most brands can operate in 30 days to 40 days. And hopefully there will be a corporate memory that the OEMs also can see this benefit and try to manage that way as we go forward. However, any time these large auto companies start fighting for market share that's when the discipline can erode." – Earl Hesterberg, President and CEO, Group 1 Automotive“It's a competitive world and you never know what someone is going to do to try and gain market share and grow their business. I think everyone's learned from the concept that we can be effective with a lower days supply and everyone can benefit from that. Does that mean we'll stabilize at a 35, 40 days supply compared to a 65 or 70? I think it's too early to tell.” –David Hult, CEO, Asbury Automotive Group“Total vehicle GPUs returning to pre -pandemic levels. […] Every day it does seem like the window for increased elevated margins are probably there for longer than we all would like or our consumers would like, but it may be that they don't return to some normalized level” – Bryan DeBoer, President and CEO, Lithia MotorsTheme 3: Used vehicle prices have runup even as compared to the price increase of new vehicles. Public auto dealers are trying to avoid being left holding the bag as the company holding too much used vehicle inventory when the music stops."It's hard to tell but we see the values starting in November, December, have adjusted meaning that they're not growing exponentially as they were before. And until the inventory levels, our belief is until the inventory levels for new cars somewhat stabilize, the used car valuation is going to remain where it is right now. And I don't -- we don't believe that when there is a correction that it will be an immediate correction. It's going to be a gradual correction. So -- but we do believe that is going to be dependent on the new DSI.” – Daniel Clara, SVP and CFO, Asbury Automotive Group“We're sitting at a 36-days supply [on used vehicle inventory…] What you worry about is the rest of the market out there that might have a 60, 80, 90-day supply, they're still sitting on cars that they paid at the height of the market, they're going to have issues. […] It's the price point, right? That's pushing demand up for new cars really because the used car price points are so high and that's got to give. And it's going to give. I mean that's going to happen. Used cars are not -- like I said earlier, are not going to continue to appreciate. We do believe we're starting to see the depreciation cycle start, if the last six weeks are any indication of that.” –Jeff Dyke, President, Sonic Automotive“The used market obviously is super dynamic. We're able to keep the inventories at the level they are because of our -- we changed our sourcing model. And the good thing about the PRUs is, we manage our inventory very tightly. So, any changes in the pricing environment we can react very quickly. I don't know when it's going to change. I feel like it's going to change at some point this year, but I don't know when.” – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveTheme 4: In the high-priced environment, more dealers are charging above MSRP or requiring customers to buy add-ons in order to get the vehicles they want. OEMs generally denounce the practice, as did some of the public auto dealers. Generally, the practice is viewed to leave consumers not trusting the dealer community.“We've seen a number of comments about vehicles being sold above MSRP, quoting the potential adverse impacts on brands and customers, which I understand. And by the way, last year, less than 2% of all the new vehicles sold by AutoNation were above MSRP. But this discussion on MSRP branded customers actually also adds to my optimism regarding new vehicle margins going forward. Because I think it's equally clear that significant discounting and high incentives can also damage a brand, which is another reason for our industry to balance appropriately supply and demand, and another reason why we may expect higher new vehicle margins than we have historically seen pre-COVID. […] I think where the issue is where you've got a short-term temporary disruption and your supply and demand curve in, what I would call, general market, mass market vehicles, where there is no history in these mass market vehicles of used prices going significantly above for a long period of time against new vehicles. And I think that is where you have to be incredibly careful.” – Michael Manley, CEO, AutoNation“We're pressing very hard for them not to bring inventory levels back to pre-pandemic levels. And so margins are going to stay high. The margins prior to the pandemic are low. We should be selling cars at MSRP. I mean this industry needs to get away from doing all the negotiating it’s a hell of a lot less complex, much easier, and it brings the right value for the vehicle. […] I just don't see margins coming back going back to pre-pandemic levels ever.” –Jeff Dyke, President, Sonic Automotive“However, our inventories are still tight and led to a majority of units being presold. As a reminder, our focus is on driving long-term relationships with our customers. We direct our stores to sell at MSRP. It helps to create the kind of sticky relationships that feeds our segment-leading aftersales performance. We realized it cost us some SG&A leverage in the short term. But for us, it's much more important to drive retention in the strongest part of our business which is aftersales.” –Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive“Our stores make those decisions in the field. And they do that based off their supply and what their competitors are doing. So yes, we do have some stores that are charging over MSRP. We don't have specific numbers because we don't specifically track it because we allow our network to make the decisions close as to what their customer base is and what the supply and demand is in that local market.” –Bryan DeBoer, President and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

In the spirit of Valentine’s Day, we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. In this week’s post, we adapt a piece written for Mercer Capital’sFamily Business Director Blog, and how it specifically relates to auto dealers. This will be the first part of a two-part blog series.Levels of Value OverviewShareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in Exhibit 1, there are three basic “levels” of value for a family business. Each of the basic levels of value corresponds to different perspectives on the value of the business. Let's explore the relevant characteristics of each level.Marketable Minority Level of ValueThe marketable minority value is a proxy for the value of your family business if its shares were publicly traded. In other words, if your family business joined the public ranks of Lithia, Sonic, Asbury, etc. through an IPO, what price would the shares trade at? To answer this question, we need to think about expectations for future cash flows and risk.The marketable minority value is a proxy for the value of your family business if its shares were publicly traded.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate. In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices. There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments. Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain. As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments. When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa. So, when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk. They will estimate this value in two different ways.When a business appraiser estimates the value of your business at the marketable minority level of value, they are focused on expected future cash flows and risk.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business. Many novice investors are aware of Price-to-Earnings ratios, and there are plenty of valuation multiples that can be gleaned from public auto dealers. While these are two distinct approaches, at the heart of each is an emphasis on the cash flow generating ability and risk of your family business. We start with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control). Acquirers are often classified as either financial or strategic.Financially motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1. Imagine a private equity buyer with no other auto dealership investments. They’ll pay for the right to earn the cash flows you’ve been generating, but other than some creative financing, they may not be able to meaningfully increase cash flows above what the current dealer principal can achieve.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded). For example, two adjacent auto dealers can likely run with a leaner management team.Strategic acquirers may be willing to pay a premium to the marketable minority value if they can achieve revenue synergies but, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value. However, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist. The name and branding may change, employees may be downsized, and production facilities may be closed. It also reduces a significant source of cash flow, as future earnings are accelerated to a lump sum payment up front. Many auto dealers have looked to exit with blue sky values high, but it’s also hard to walk away during a time of record profits in a business that can operate throughout the business cycle.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value. All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.The buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value.What factors are investors at the nonmarketable minority level of value most interested in? First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business. But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest? The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold. The longer an investor expects the holding period to be, the larger the discount to the marketable minority value. Imagine you own a 5% interest in a dealership that you’re looking to sell. If a potential buyer knows the dealer will “never sell to one of the big guys,” that will impact how much they’ll pay you for your interest.Expected capital appreciation. For most family businesses, there is an expectation that the value of the business will grow over time. Capital appreciation is ultimately a function of the investments made by the family business. Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return. Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares. All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value. Auto dealerships tend to have pretty strong cash flows, and relatively limited opportunities to reinvest in the business. While the OEM has imaging requirements every so often, the opportunity to meaningfully expand operations tends to be tied to adding on more rooftops.Interim distributions. Does your family business pay dividends? Interim distributions can be an important source of return during the expected holding period of uncertain duration. Interim distributions mitigate the marketability discount that would otherwise be applicable. High levels of distributions may be common for minority investors in auto dealerships. However, minority investors cannot compel these distributions themselves, and we’ve seen many cases where the cash simply builds on the balance sheet. As noted above, this can drag on returns.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above. As a result, they demand a premium return relative to the marketable minority level. The greater the perceived risk, the larger the marketability discount. A strong capacity for distributions and opportunities to be sold to a strategic buyer can push down marketability discounts for auto dealerships. Conversely, sporadic distributions and cash buildup can lower expected returns. And while dealerships must send monthly factory statements to the OEM, these don’t commonly get shared on a regular basis with minority investors who may not have a good pulse for how their dealerships are performing.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Hopefully, we’ve illustrated the “why” behind the various levels of value. In our next post, we’ll cover why getting the Level of Value correct is so important, and we’ll discuss numerous instances where a dealer may encounter the value of their store from different levels.

Just as December is a good time to look back and reflect, January is a good time to look forward, to 2022 and beyond. When we value auto dealerships, we look back at performance in prior years because this helps to inform reasonable expectations for future performance. Prior to the pandemic, the directly preceding twelve months of performance may have been a reasonable proxy for ongoing expectations. However, throughout 2020 and 2021, discussions about when things will return to “normal” or whether we’re in the “new normal” have taken center stage.In order to look forward, we must also consider the past, or as Shakespeare’s Antonio would say, “What is past is prologue.” In this post, we look at two key trends in 2021 (inventory shortages and electric vehicles/direct selling) and how they may inform how automotive retailing will look in the future.Inventory ShortagesIn case you’ve been living under a rock (or working from home and refusing to turn on the news), new vehicle inventory has been tight, reducing availability and raising prices. While a lack of necessary microchips has stolen headlines, general supply chain issues are also at play (labor shortages, plant shutdowns due to COVID, etc.). From Econ 101, we know low supply leads to higher prices. And even though operating expenses have increased 16.3% for the average auto dealership in the U.S., pre-tax profits more than doubled in the first nine months of 2021.This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.For years, retail has been obsessed with discounts. Think 10% for signing up for a mailing list, free shipping for orders over $25, or straight to the point: Black Friday/Cyber Monday. Automotive retailing is no exception, with incentives reaching above $4,500 per vehicle prior to the pandemic. As discussed last week, incentives have plummeted in the low inventory environment. Unlike knick-knacks bought in the Christmas season, many car buyers don’t have a reasonable substitute. When their car breaks down, they need a vehicle and can’t wait months for inventory levels to normalize. This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.Auto dealers and their manufacturers are much more profitable under the current operating environment while producing fewer vehicles, reducing execution risk. It’s easy to chalk up these good times to temporary dislocations caused by COVID that will eventually normalize. But in a capitalist society, economic downturns tend to bring back the phrase attributed to Winston Churchill around World War II, “never let a good crisis go to waste.” OEMs will look at how they’ve adapted since March 2020 and look to keep profits higher with more efficient operations.Once the pandemic is finally in the rear view mirror, we think the level of inventories held on lots will be lower than pre-pandemic levels. While there is still a value to testing out the product before purchasing, we’ve seen other retail industries that hadn’t yet succumbed to ecommerce where certain buyers are now willing to buy sight unseen (see mattresses in a box). This shift in auto will reduce floor plan costs for dealers who can also downsize their real estate holdings or convert it to more service areas if they can find the technicians to fill the bays they already have. Smaller real estate requirements may enable dealerships to move to more cost-effective locations.But the main concern from dealers we’ve talked to is this: what if prevailing supply conditions fundamentally change the franchised dealer model?History of Dealer FranchisingTo understand the status quo of automotive retailing, we start at the beginning, when automotive manufacturer franchising of dealerships began in 1898. Back then, there were numerous methods of selling vehicles, including franchise locations, direct sales from factory-owned stores, traveling salesmen, wholesalers, retail department stores, and consignment arrangements. As automobiles proliferated, manufacturers preferred outsourcing sales to the franchise model, so they could focus on their core competency of manufacturing vehicles. They would rely on entrepreneurs to understand their local market in terms of which models were popular and where best to situate the dealership within the market. This also lowered investment for the manufacturers who could instead plow those resources back into product development.The franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.Once this investment was made by numerous “mom and pop” shops throughout the country, dealers lobbied to protect their investment. It was deemed unfair for the Big Three (Ford, GM, Chrysler) to be able to sell directly to consumers in lieu of through its dealers. Manufacturers already operate from a position of power as the sole provider of new vehicles to its franchisees, a risk known in valuation as “supplier concentration.” OEMs can unilaterally determine production levels, and according to a 1956 Senate Committee report, franchise agreements of the 1950s typically did not require the manufacturer to supply the dealer with any inventory and allowed the manufacturer to terminate the franchise relationship at will without any showing of cause. Manufacturers could overproduce and force dealerships to accept the cars with the threat of no inventory in the future. This occurred with Ford during the Depression. Thus, the franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.For perspective, restaurants don’t have similar franchise protections. For example, McDonald’s has both corporate owned and operated locations as well as franchise locations (approximately 93% of locations are franchisees). In this industry, there is heavy competition and franchisors often test out new products in their own locations before rolling them out to franchisees. This is quality assurance and also gives franchisors the ability to point to the success of a product so franchisees don’t feel like they’re being forced into something that may not appeal to their customers.While dealers made numerous lobbying efforts at the Federal level in the 1930s to 1950s, they made little headway. In fact, a 1939 Federal Trade Commission report found that manufacturers pitting dealers against each other actually led to an intense retail competition which ultimately benefitted consumers. To get the protections they sought, dealers turned to state legislatures, which is why franchise laws are largely handled at the state level. Today, all 50 states have laws that protect dealers, though the strength and terms of these laws varies by state. Common terms include the prohibition of forcing dealers to accept unwanted cars, protection against termination of franchise agreements, and restrictions on granting additional franchises in a dealer’s geographic market area. As many dealers today know, the OEMs still have significant bargaining power in these latter two areas.Direct SellingThe current market dynamic has prevailed for generations through numerous business cycles. Today, dealers are concerned that manufacturers may use electric vehicles (“EV”) as a means to skirt dealer franchise laws. Tesla has been very successful, particularly if you look at their share price, with its direct-to-consumer electric vehicle sales. OEMs naturally would like a piece of this (or anywhere near their valuation multiple).While Tesla has encountered legal troubles with its direct selling model, it’s important to note the difference between Tesla and other manufacturers. Tesla never pursued a franchise dealer model. Therefore, direct selling cannot disadvantage dealers of its vehicles since they don’t exist. Tesla offers a luxury product and has yet to reach a meaningful scale. Unlike OEMs of the early to mid-1900s, their product has not garnered mainstream demand, and they can therefore be competitive in their niche by keeping few parties in between the manufacturer and the consumer. While the below graphic is instructive, the OEM tends to play the role of plant, distributor, and wholesaler, meaning there’s really only one extra layer between manufacturer and consumer in this industry. Dealers naturally contend that direct-to-consumer EV sales should not be allowed as it could be a slippery slope to allowing the sale of all vehicles directly. There is nothing inherently different about the manufacturing and selling process as it relates to the powertrain of the vehicle. Tesla’s exception is not electric; it’s the lack of an existing dealer network. However, one of the benefits of the current dealership model is that consumers can return to the dealership to service their vehicle. If EVs deliver on their promise to require less maintenance than internal combustion engine (“ICE”) vehicles, maybe the need for this dealer network will be diminished in some regard. For now, electric vehicles are too expensive to be mainstream, but significant progress has been made on lithium batteries which have lowered costs. Still, massive investments in infrastructure will be necessary to make EVs practical. Electric vehicles are only 2.9% of the market, though combined with hybrids, alternative powertrains amount to 9.5%, with the remaining being internal combustion engines. While this is a relatively small piece of the market, it will likely grow over time.Source: NADA Market Beat December 2021ConclusionGiven the complexity of manufacturing automobiles and the heterogeneous preferences of consumers, we don’t think the recent shift to “just-in-time” delivery out of necessity will last. We believe electric vehicles will compose a much more meaningful market share, though we are less certain on the timing. While there are various proclamations of carbon-neutral by 2050 and the like, we think the market will determine when and how much electric vehicles hit the mainstream. If improved technology reduces costs and fears of range anxiety, EVs could be on the same playing field or even advantaged over ICE vehicles with higher upkeep costs (service and gas).We don’t believe electric vehicles will meaningfully change dealer franchise laws. However, we believe the trends we’ve seen of smaller stores being gobbled up by increasingly larger auto groups will continue, which is partially due to the threat of direct selling. However, smaller dealers are also getting out with valuations peaking, tax policy uncertainty, and increasing capital requirements to invest in digital platforms, automated systems, and the infrastructure to support electric vehicles rather than the direct selling of these vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

2021 was an interesting year for many businesses, and it was certainly interesting for auto dealers. While automotive retailing may be an attractive space for purely financial investors, many dealerships are owned by the same folks that run the business. So while inventory shortages and other headwinds played a role in heightened profits in 2021, the return on investment achieved came with many operational headaches.Just about everyone we’ve talked to acknowledges that current performance is not indicative of ongoing expectations. The question has largely been focused on when we’ll revert to the mean, but this post touches on what things will look like when we return to a more “normal” operating environment. Specifically, what negative equity from used car buyers in 2021 may mean for dealerships.Used Car PricesIn a recent whitepaper, KPMG warned that used vehicle prices could fall abruptly and raise negative equity issues once new vehicle supply rebounds.  Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth. We’ve all heard about a vehicle losing value once you drive it off the lot and it's true. Compounding this problem is the expectation that values today will materially decline in a year or two which increases the likelihood of negative equity.Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth.In April 2020, during the depths of the pandemic,  44% of trade-ins carried negative equity – more than double the amount seen a decade earlier. The average negative equity then was $5,571. A year later, vehicle prices increased significantly, but average negative equity only declined by a little more than $1,000. More importantly, the proportion of trade-ins with negative equity was relatively constant, meaning nearly half of buyers were looking at their trade-ins adding to the price of the vehicle they were looking to buy.According to our analysis of NADA data from 2011 to 2020, used vehicle retail prices increased at a compound annual rate of 2.7%, just above the 2.6% increase for new vehicles. In 2021, used vehicle prices lurched forward faster than new vehicles. New vehicle prices increased 7.5% in the last twelve months due in part to supply shortages. Consumers who couldn’t get the new vehicle they wanted or realized they needed a car, but prices were too high, may have turned to used vehicles, whose prices increased 19.1% due to increased demand.The ratio of used-to-new vehicle prices was 62.5% through October 2021, notably higher than the 56.5% observed in October 2020 and above the long-term average (2011 to 2020) of 57.1%. Used-to-new retail volumes were also 91.9% for the first ten months of 2021, higher than any full-year since at least 2011. Used vehicles have become increasingly important to dealers, as this figure has steadily increased from a recent low of 73.9% in 2015.What will happen if new vehicle supply is restored and used vehicle prices crater?As KPMG warns, what will happen if new vehicle supply is restored and used vehicle prices crater? Applying the long-term average used vehicle price appreciation of 2.7% to the $22,027 average used vehicle retail price in 2020, it would take until 2027 to reach $26,000. As of October 2021, the average retailed used vehicles cost $25,904. If used car prices revert to the long-term relationship of new car pricing (57.1% of $41,421 for new vehicles as of October ‘21), we would see a decline of 8.7%. KPMG indicated “a 20-30% plunge in used vehicles costs is within the playing cards.” This would almost certainly wipe out any consumer's equity who elected to finance their purchase.Consumers are able to buy more expensive cars when they get what they perceive to be a good deal on their trade-in, and higher used vehicle prices mean trade-ins are more valuable. However, this important source of cash for buyers will evaporate if used vehicle prices plunge, and negative equity just adds on to the price of a vehicle, putting pressure on how much consumers can pay up for a new vehicle. As noted previously, through April 2021, a significant number of buyers still had negative equity despite advantageous pricing on used vehicles. This could spike if prices crater.What It Means For DealersGiven the long life cycles of vehicles, dealership performance tends to ebb and flow with the economy. Executives of public retailers harp on the importance of touchpoints with the consumer, meaning they return to the dealership to get their car serviced. Dealers also hope customers return to their showrooms when it’s time for another vehicle, and the experience from the last purchase will likely play a big role.If consumers are unsatisfied with their purchase because prices were elevated when they bought in 2021 and decline significantly thereafter, they may feel aggrieved and choose to go with another dealership. While this situation is largely unavoidable for most dealerships, it could have negative ramifications down the line. Consumers may also choose to hold onto their vehicles longer to not recognize the loss by trading in. While it’s unclear how this will shake out down the road, dealers will need to prepare themselves for difficult conversations.Through the first ten months of 2021, the average dealership has already made nearly $3.4 million.As we alluded to previously, profits are up for dealerships in 2021. According to the NADA, the average dealership earned average pre-tax profits of $1.4 million from 2011 to 2020. Average pre-tax profits reached above $2.1 million in 2020, which was the first time above $1.5 million since 2015. Through the first ten months of 2021, the average dealership has already made nearly $3.4 million with two more months to add to these totals.The value of auto dealerships is communicated through Blue Sky values, which are based on a multiple of pre-tax earnings. While dealers aren’t likely to get a high multiple on peak earnings, we note both Blue Sky values and multiples are up since before the pandemic. However, once performance normalizes, dealerships may not be worth as much as they are now, much like the vehicles they sell. This would likely explain the record amount of M&A activity seen in 2021 with some of the largest dealer groups opting to sell.According to the Q3 2021 Haig Report, the average franchise has a Blue Sky multiple of 5.24x and adjusted pre-tax earnings of $2.08 million for a Blue Sky value of about $10.9 million, up 61% from year-end 2019 to all-time highs. At these prices, buyers must be optimistic that the good times will continue, multiples won’t crater, and/or the new normal of profits will be higher than historical levels.Source: Haig Partners Haig’s estimated pre-tax earnings of $2.08 million as an ongoing figure today is about 46% below current levels based on our calculations of NADA figures. However, according to NADA, it coincidentally represents a 46% increase over the 2011-2020 average for the average dealership. While that makes the ongoing figure appear reasonable, the chip shortage universally viewed as a temporary problem is far from “normal.” Suppose current estimates of ongoing earnings end up being overly optimistic, with an increased focus on recent outperformance. In that case, the values of dealerships, like the vehicles they sell, are likely to decline.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The stock market is near record highs despite the global economy still working on climbing out of a once-in-a-century pandemic. A couple of themes for high-flying equities are ESG and companies that have yet to turn a profit. Rivian Automotive takes this a step further, as its prospectus indicates it will lose $1.28 billion in the third quarter while revenue will range from $0 to $1 million. However, as of its opening price, Rivian is already worth more than Ford and GM. From a valuation perspective, all the value is clearly placed in the terminal value with minimal production to date.Amazon and Ford are backing the electric vehicle startup, and investors are clearly betting the company can grab a meaningful amount of the burgeoning EV market. Rivian has beat Tesla, GM, and Ford to market with a fully electric pickup truck, the R1T. While this is expected to launch in December, it remains to be seen how meaningfully the company can scale production—if it can’t, being first may not mean much.Rivian indicates its factory in Illinois has the capacity to produce approximately 65,000 pickup trucks/SUVs and 85,000 commercial delivery vans, the latter of which is why Amazon is interested. Amazon owns 20% of Rivian and has ordered 100,000 Rivian vehicles to be delivered by 2030. Ford was also interested in collaborating on production for its EV business. The investment increased to become a meaningful part of Ford’s market capitalization, regardless of synergistic opportunities. However, on Friday, it was announced that Ford and Rivian had canceled their plans to jointly develop an EV.There are numerous potential reasons for this split, and Rivian indicated the decision to split was mutual. When Ford invested in Rivian in 2019, it was likely viewed as a way to jump-start its EV initiatives. Since then, Rivian’s production has been de minimis while Ford sold about 22,000 Mustang Mach E's alone in 2021, which was named Car and Driver’s Electric Vehicle of the Year. While Ford will continue to benefit from its investment in Rivian, it doesn’t “need” Rivian to be successful in EVs.Below, we have included a recent blog from my colleague Atticus Frank on Mercer Capital’s Family Business Advisory Services team, highlighting the decision to invest in Rivian from Ford’s perspective.Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) startup that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car startup, giving it an implied stake of over $18 billion. Not bad, given its sub-$1 billion of invested capital. If one were to do a “back-of-the-envelope” sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization. We don’t highlight the current irrational exuberance to spur you into investing in an EV startup or give you a case of ‘FOMO’, but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why? What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is a correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation. We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article. When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative. However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the startup) is yet to be seen. Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different ‘who’ regarding diversification and a different ‘why’ to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business. Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the ‘why’ for significant investment decisions. How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision. Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.“If I had asked people what they wanted, they would have said faster horses.”“Any customer can have a car painted any color that he wants so long as it is black.”Takeaways From RivianAuto dealers are unlikely to be able to invest in the next Rivian, but that doesn’t mean there are no lessons to be learned here. The market is clearly indicating it believes EVs are the future, so dealers should be positioning themselves accordingly. With heightened margins in 2021, auto dealers need to decide the best way to reinvest their capital. That may mean using profits earned in the past years and investing in infrastructure to support EVs. Local markets will still be necessary and there won’t be a one size fits all solution, but Rivian making headlines should get auto dealers thinking about what it means for them.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.In addition to auto dealers, Mercer Capital also provides financial education services and other strategic financial consulting to family businesses. Click here to learn more about our Family Business Advisory Services.

Inflation and interest rates are on more people's minds lately due to supply chain disruptions across all industries. People understand how inflation and interest rates affect their daily lives when noticing the rising cost of goods/services and the cost to borrow money to buy a house, but many don't realize that inflation and interest rates are interconnected. Inflation and interest rates are frequently linked when discussing macroeconomics and they tend to have an inverse relationship. When interest rates go up, in theory, inflation goes down. However, there are many more factors other than inflation and interest rates impacting the economy in the real world.In this post, we discuss how we got to our current reality, what auto dealers might expect regarding inflation and interest rates, and how it all might impact the dealership.How Did We Get Here?Back in April, Federal Reserve Chair Jerome Powell indicated the Fed wasn’t close to raising interest rates, labeling inflation as “transitory.” At the time, he cited strengthening economic indicators, including employment and household spending and continued vaccinations which were expected to ease uncertainty and continue the economic recovery.According to Powell, “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future.” Further, the Fed indicated that clogged supply chains would not affect Fed policy as they were seen as temporary and expected to resolve themselves.While this transitory stance appeared reasonable at the time, confidence in this stance has waned and the Fed has begun signaling it would end its accommodative policies. Below we’ve included the first chart and table in the September edition of the Consumer Price Index (“CPI”) published by the Bureau of Labor Statistics last Wednesday (October 13, 2021).Source: Bureau of Labor Statistics- Consumer Price Index-September 2021Source: Bureau of Labor Statistics- Consumer Price Index-September 2021In our view, the graph of 12-month change supports the transitory view, at least in the beginning. Comparing prices in April 2021 to April 2020 is not very meaningful given the significant impediments to the economy at the time. However, as seen in the tables above, inflation has persisted on a monthly basis over the past six months.  While 0.3% and 0.4% growth in the past two months is an improvement over March through July, it shows that the problem continues to linger.Are inflationary pressures still expected to be brief and transitory?On Tuesday, the day before September inflation numbers were published, Atlanta Federal Reserve President Raphael Bostic indicated inflationary pressures “will not be brief” and that he and his staff would no longer refer to inflation as transitory. Notably, Bostic is a voting member of the 2021 Federal Open Market Committee, and his public statement is the first to our knowledge challenging the transitory narrative. However, it shows how the Fed has evolved its stance over the past six months.In March, the Fed signaled it wouldn’t raise the Federal Funds rate until at least 2024. In June, the Fed stood by its transitory stance but began to indicate rate hikes would come sooner as the dot plot of expectations from FOMC members indicated two rate hikes in 2023. By September, half of Fed policymakers are expected to start raising rates in 2022, as seen below. While the timing of rate hikes is uncertain, it appears that accommodative policy will be eased in the not so distant future. What does that mean for auto dealers? Impact of Inflation on Auto DealershipsNotably for auto dealers, used vehicle prices surged by over 10% month-over-month in both April and June, which accounted for about a third of the total increase in the CPI for those periods. According to Cox Automotive Chief Economist Jonathan Smoke back in July, used vehicles were “the poster child illustration for transitory price hikes." While used vehicle prices, according to the CPI, have come back down to Earth in recent months, including decreases of 1.5% and 0.7% in the past two months, new vehicles have seen monthly growth of at least 1.2% since May due to supply shortages.New and used vehicle retail prices continue to climb to all-time highs. Even despite lower volumes, dealers are seeing higher revenues.  Through August 2021, the average dealership was getting $3,668 in retail gross profit per new vehicle retailed. Through April of this year, that figure was $2,906 indicating a widening of profits for dealers on a per unit basis. This has played a role in the outsized profits achieved by auto dealers in 2021, who are likely wondering how long this can last.In our view, prices will continue to rise in the short-term due to supply constraints. However, consumers are becoming increasingly aware of these higher costs, and new vehicle buyers are likely delaying purchases if they are able to wait. While businesses across all industries are able to point at supply shortages and COVID as reasons for higher prices right now, at some point buyers will leave the market to wait for prices to normalize.While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position because dealerships have numerous complimentary profit centers. But how long will it last?While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position. As we’ve discussed before, auto dealerships have numerous complimentary profit centers. If a customer can’t find the new vehicle they want, a deft salesman can get them into a used vehicle. When consumers delay purchases of a vehicle, they put more mileage on their current vehicle, driving business to the higher margin service and parts operations. With fewer vehicles put on the road in 2021 due to shortages, we see a runway for more vehicle sales, even if the profit per unit declines. In the medium term, parts and service may be the area to watch. Fewer vehicle sales means parts and service will eventually dip in the future, though this likely won’t be felt for a few years. It will also be interesting to see where consumers get their vehicles serviced after purchasing from online used vehicle retailers that don’t have these operations. Along with the factors already mentioned, the future path of inflation for vehicles will likely also be impacted and interconnect to the path taken by interest rates.Impact of Interest Rates on Auto DealershipsAccording to an interesting Lexington Law study on how Americans are buying cars, auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide. When interest rates fall to the prevailing low levels, consumers are able to afford more expensive cars. However, the mathematical movement of lower interest rates doesn’t necessarily mean consumers will correspondingly purchase a more expensive car. Similarly, when interest rates rise, that doesn’t mean vehicle prices have to decline. Still, dealers should be aware that this is the case, at least in theory.Interest rates matter. Auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide.In practice, F&I departments can smooth out rising interest rates or rising vehicle prices by extending the length of loans. According to Lexington Law study, the amount of the monthly payment was the top priority for the average car buyer. It is natural for people to consider their monthly out-of-pocket costs and what they can afford, even if it leads to a longer loan term or higher interest rates. We should also note that APR and total interest paid are similar considerations, which when combined, amount to almost half of the decision.Source: Lexington Law | Study: How Are Americans Buying Cars?Rising interest rates will increase costs to consumers and if they’re on a fixed budget, this places downward pressure on vehicle prices. In December 2015, the Fed raised rates for the first time since the Global Financial Criss. Dealers will have to lean on their past experience on how to navigate vehicle sales in an environment of rising interest rates. Interest rates don’t only affect top line revenues for dealerships, however. The prevailing low interest environment and inventory shortage has significantly reduced one key operating expense for auto dealerships: floor-plan interest expense. Lower interest rates mean the price of keeping inventory on the lot for test drives is lower. With lower levels of inventory, interest expense is being reduced by volume as well as price. With inventories expected to normalize and interest rates expected to creep up, auto dealers will see floor plan expenses rising. It may not get back to pre-COVID levels if OEMs structurally change the level of inventories kept on dealers’ lots, but that’s another topic for another blog post.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by the greater macroeconomic environment. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo.  Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

As we discussed in the first installment of this blog series, there are six primary publicly traded companies that own approximately 923 new vehicle franchised dealerships as of Q2 2021, or 5.6% of the total number of dealerships in the U.S. (16,623 at year-end 2020 per NADA). This demonstrates how fragmented the industry continues to be, despite recent consolidation.The total number of dealerships has remained largely the same, though the number of dealers is dwindling as big shifts towards e-commerce accelerated by the pandemic require heavier investment for smaller operations to compete.This issue of consolidation is not limited to just mom and pop stores.According to the Wall Street Journal, Suburban Collection of Michigan sold to Lithia this year in part due to the need for outside capital. David Fischer Jr. and his father sought a strategic partner to update their business to the new digital retailing environment despite having 56 franchises across 34 stores. In 2020, Suburban Collection was the 21st ranked auto group in terms of size, retailing just under 30 thousand new vehicle units.Given current blue sky values, the size of the deal and Lithia’s aggressive acquisition strategy, we realize premium pricing may have ultimately won the day in the Fischers’ decision to divest. Still, for an auto group of that size to be seeking a minority partner, prior to eventually being acquired, is noteworthy. We’ve also heard concerns from our clients that the potential for rising taxes and tweaks to the supply chain (with OEMs considering a model that reduces the autonomy of dealers) could lead to further consolidation.Our goal with these posts is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit in benchmarking to public auto dealers. Smaller or single point franchises may find better peers in the average information reported in NADA’s dealership financial profiles or more regional 20 Group reports. Public auto dealers also give dealers insight to how the market prices their earnings, the environment for M&A, and trends in the industry.Sonic Automotive Locations and BrandsBased in Charlotte, North Carolina, Sonic has 84 franchised dealerships, the lowest of any publicly traded company that operates principally as a new vehicle dealer. As seen below, the company earned over 50% of its revenue in Texas and California, with another 30% of 2020 revenue coming from Colorado, Tennessee, Florida, and Alabama. By year-end 2021, the company projects 25% population coverage. While the company is smaller and relatively concentrated in terms of its footprint compared to its public peers, Sonic is targeting 90% population coverage by 2025 (see projection below in recent investor materials). This growth will largely come from its EchoPark segment comprised of physical locations selling pre-owned “nearly new” vehicles with many having remaining OEM warranty. According to the Automotive News Top 150, Sonic sold the seventh most new retail units in 2020, at just over 93 thousand, trailing the other public dealers and Hendrick Automotive Group, the largest private auto group, also based in Charlotte. As seen in the table below, 55% of Sonic’s 2020 revenues came from Luxury brands, particularly BMW and Mercedes. This is more than double the company’s combined sales from domestic (10%) and EchoPark (15%), which are assumed to target a lower price point. Assuming continued growth in EchoPark, Sonic appears to be targeting consumers at various income levels which should provide balance in any market environment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. Sonic’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume based incentive fees, operating income can be negative for dealers before accounting for these profits.Due to differences in reporting, Sonic captures other income along with F&I as a revenue item with no corresponding cost of sales line item. The minimal amount of reported other income/expense not included as revenue if added to gross profit, would not change its reported gross margin of 14.85% by one basis point.Interestingly, its gross margin through the first half of 2021 was down immaterially from 14.89% in 2020. This comes despite industry-wide improvement in gross margins and a pickup in margin for new vehicles, whole vehicles, and parts, service and collision operations. That means Sonic has been negatively impacted by its declining margins on used vehicles (2.8% compared to 3.6%) and/or the contribution of gross profit (relatively less high margin fixed operations and/or more used vehicles).While EchoPark likely explains this, it is interesting to contrast to the average dealership as reported by NADA which saw gross margin improve from 11.8% to 13.4% in the first half of 2021. While this appears lower than the figures reported by Sonic, we note the difference between operating profit and pre-tax profits (largely aforementioned back-end profits) was 2.3% of revenues, which added to gross margin, would be 15.7%.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on Sonic Automotive. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Sonic’s Blue Sky value per share is approximately $35.19.Given recent outperformance, Haig Partners prescribes a 3-year average be taken in determining ongoing pre-tax income (2018, 2019, and LTM June 30, 2021). Using this methodology and applying the 25% tax rate implied by Sonic’s financials, its ongoing pre-tax earnings per share would be $4.97 or just over 7.0x Blue Sky. While this is lower than all of its public counterparts besides Group 1 Automotive, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential as well as its tilt towards luxury brands. ConclusionAt first glance, Sonic may appear to be a close comparable for private auto groups. Unlike other public auto dealers, it does not have other business lines (Penske) or international operations (Group 1). It’s not rapidly acquiring other dealerships (Lithia) and its franchised dealership count is about a third of AutoNation. However, like Asbury, it is tilted towards luxury with very little domestic sales, and still has significantly more dealerships than most groups.Sonic also has meaningful used-only operations in EchoPark, which is where the company is allocating much of its capital. Geographic diversification and access to capital markets can also materially impact comparisons, particularly for smaller dealerships. Still, management commentary on the macro environment in the auto dealer space is valuable and appropriate benchmarking comparisons are still possible if you know what you’re looking for.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers, gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely. OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements. Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements.  To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

As our dealer clients know, automotive retailing competition has intensified with large, well-capitalized online-only retailers getting plenty of attention. Due to imbalances between supply and demand, gross margins on both new and used vehicles have increased in 2021.In this post, we survey gross margins for the publicly traded dealerships, in light of the current operating environment and reconsider the investment thesis put forth by the new entrants.Investment Thesis of Online Used-Only RetailersInvestors in used-only retailers likely have numerous reasons for believing in these companies. We’ll highlight some of the reasons below, then delve deeper into a few of them.Lack of franchise agreements in used vehicle space enable significant growth/market reachCOVID-19 anticipated to accelerate auto retailing towards e-commerce seen in other retail sectorsCustomer dissatisfaction with traditional retail experienceGross margins tend to be higher on used vehicles than new vehiclesAsset-light business modelLack of Franchise AgreementsFor the publicly traded traditional auto retailers, franchise agreements can inhibit growth. Executives have discussed on earnings calls the obstacles that can occur when they accumulate numerous stores in the same brand. For used-only retailers, there are no similar restrictions as the sale of used vehicles are not subject to franchise agreements. While this may be a positive for growth and geographic diversification, this limits the market available to these companies.Vroom’s 2020 investor deck highlighted used auto as one of the largest markets at $840B trailed by grocery ($683B) and new auto ($636B). Using these figures (which are pre-pandemic), used-only players are limited to ~57% of the market.While growing to become the premier used vehicle operator would have obvious benefits, if any of these players can meaningfully consolidate the highly fragmented market, there is a downside to only interacting with consumers when they want a used vehicle. This is also why executives of franchised auto dealers have started harping on the number of "touch-points" they have with consumers which includes new and used sales as well as service appointments. source: Vroom, Inc.COVID-19 and the Shift to EcommerceA core strength of pre-pandemic automotive retail was the lack of penetration from ecommerce. As seen above, ecommerce penetration prior to the pandemic was less than 1% as determined by Vroom. The space has been Amazon-proof to a degree, though auto dealers and consumers were thrust into a digital world last March and April. Over a year later, it seems clear that the number of transactions and the percentage of transactions completed online will increase.Online retailers tout that they are the future, and the pandemic has only accelerated trends in consumer preference towards online. Only time will tell how truly transformed the environment is. Does the lack of ecommerce penetration represent a massive opportunity for new entrants in the market, or does it just paint a picture of how difficult it will be for these companies to attract profitable market share?Gross Margins and Profitability at LargeAnother long-term key consideration will be profitability. As with Amazon and Facebook, tech companies can command huge valuations prior to turning profitable. Many Silicon Valley startups claim to be the next unicorn that will achieve scale, ramp down expenses relative to revenue growth, and watch red ink turn to black.Because Carvana, Shift, and Vroom are still relatively young companies, their lack of profitability has not yet detracted from their value. However, gross margins can still be compared because companies spending significant amounts on advertising will have a hard time turning the corner if the unit level economics aren’t there.Let’s revisit what was mentioned at the outset. Used vehicle margins have been stronger than new vehicle margins. That remains to be true. Gross profit margin for the average dealership through the first half of 2021 was 13.4%, up from 11.8% through 1H20. For the new vehicle department, gross as a percentage of selling price increased to 8.3% YTD 2021, up significantly from 5.5% in the prior year period. The same is true for used vehicles: 14.0% YTD 2021 versus 11.4% in 2020. New and used margins are up in 2021, and used margins continue to outpace new.Parts and service departments have higher margins than vehicle sales departments, and these departments account for a significant portion of gross profit for auto dealers. According to NADA, through the first half of 2021, gross profit contribution from parts and service was considerably lower than historical levels (37.4% of total gross profit), but it still outpaced that of both new and used vehicle departments despite making up a much lower percentage of revenue. Below, we have calculated gross margins in 2021 for the public auto dealers.Click here to expand the image aboveUsed vehicle gross margins exceed new vehicle gross margins for Asbury, AutoNation, Group 1, and Lithia. Notably, however, that is not the case for Penske, LMP, or Sonic. Sonic’s 2.8% used vehicle gross margin stands out as an outlier, but we do see here that used vehicle gross margins are not exclusively higher than new. This could be due to the difficulty of sourcing vehicles in this environment.LMP and Penske also have the highest new vehicle margins, which could be at the detriment of used vehicles margins if they extract higher ASPs on new vehicles by offering higher trade in values.For total gross margin, however, the impact of fixed operations is clear. Blended total gross margin for traditional franchised auto dealers is approximately 15-18%. For used-only retailers, used and total gross margins are much lower as seen below.Click here to expand the image abovePerhaps these retailers are underpricing their vehicles to gain market share, and it is true that lost incremental vehicle sales from these retailers has a compounding effect. In addition to a lost vehicle sale, consumers are also less likely to go to a dealership for parts and service if they didn’t originally purchase the vehicle from that dealership. While this could have a long-term negative impact on total gross profit for dealerships, it remains to be seen if there will be mass adoption to buying vehicles from these platforms. Unless there is a material change in franchise laws, these companies won’t be able to sell new vehicles.ConclusionUsed-only online retailers may be the future. Customer dissatisfaction with "the old way" may push more people to try something new. The Carvana's of the world may improve their gross margins with data-driven technologies lowering costs and tactfully raising prices without losing their new customers.The asset-light model may help attract enough investors to lower the cost of capital for larger players enabling a virtuous cycle of greater scale and efficiencies. These players may eventually also look to get into the service and parts business to improve gross margins, though this would be hard to square with an asset-light approach.For now, though, franchised auto dealers will continue to operate with the strong foothold afforded to new vehicle dealers that can cater to customers throughout the life cycle of their vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent. While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets.  It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income.  As discussed below, there are also other tax planning benefits from this structure. Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent.  As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations.  If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.

The earnings calls in Q1 began with a focus on many of the same trends as prior quarters: increasing or record EPS despite inventory struggles as gross margin improvement drove operating leverage. The chip shortage has taken center stage, with cloudy expectations of when inventory levels might normalize. Contrast to factory shutdowns last year, dealers are faring much better as strong demand has improved vehicle pricing, benefiting both dealers and manufacturers. OEMs have tried to mitigate the impact of the chip shortage by removing certain features requiring chips, while others have prioritized more in-demand models to maximize profits.A couple of other trends require the proper framing of the subject to truly understand what’s happening. First, many execs talked about “pent-up demand” for parts and service work. If “pent-up demand” means parts and service revenue is expected to increase in the coming months, then that appears likely as vaccination rates increase and mandates are relaxed. However, on previous calls, many discussed the notion of consumers deferring maintenance on their vehicles since they could get by because they were driving less. Deferred maintenance has not been discussed as much, suggesting deferred maintenance activity has not meaningfully presented itself. In many instances such as the winter storms, execs noted that unit sales may have been delayed but service revenue losses would not be recovered.We also need to appropriately frame the degree to which online sales are truly “incremental,” or not cannibalizing traditional in-person sales. Execs highlighted online sales to customers who had not previously bought from them before as evidence that online tools were incremental. Given the long life cycle of vehicles, we are less convinced this necessarily says a consumer only purchased from their company because of the online feature. While Lithia noted nearly 98% of its online sales were to first time Lithia purchasers, we believe the 43% sold to customers outside of their retail market presence is a better representation of incremental sales, which is to say the company is improving its market share. While there were technical difficulties throughout the Sonic call reducing our ability to pull meaningful quotes, their investor deck similarly noted 30% of customers of its EchoPark segment (its stand-alone Pre-Owned operations) traveled more than 30 minutes to shop their inventory.On the other hand, Penske casts doubt on the notion that these sales were truly additional in the sense that consumers aren’t buying cars they didn’t otherwise need solely because the option to buy online now exists. While we tend to agree, it is meaningful if larger players are able to poach customers with the scale provided by their online platforms. Over the longer term, this could negatively impact unit volumes for smaller dealerships who choose to not take advantage of online options or are not able to meaningfully compete. Simply having a website may not be enough for the local Honda dealership to compete if comes up 5th on a Google search.The franchised auto dealer space is fragmented by nature. As such, the few publics are frequently asked about consolidation in the industry, as they have both the experience to operate at scale and a liquid market for their equity which allows acquired dealers to achieve liquidity without necessarily losing the upside of their dealership in a transaction (either receiving stock or investing cash from the deal into that stock). However, despite plenty of transactions in the industry, public auto dealers have not typically provided much financial information on their targets aside from revenues. In a recent investor deck, Lithia took things a step further, quantifying its intangible investment as a percentage of revenues as shown below: Many noted increasing valuations, and an analyst on the AutoNation call mentioned his M&A modeling at about 15% to 30% of sales.  CFOs for multiple companies noted their focus on EBITDA multiples when doing deals, which are highlighted in theme #4.  For perspective, the market ascribes about a 7.7x EV/EBITDA multiple for AutoNation with floor-plan interest treated as an operating expense as calculated below: Theme I: Microchip shortages have extended longer than initially anticipated, but strong demand, in part due to stimulus funds, has supported robust sales and gross profits. The industry’s limited chip supply has led to retail customer, particularly in hot selling models, getting vehicles first.“As it relates to the hot selling products as you point to, the OEMs are really great at this.  And while the chip shortage is there, they've really been shifting their production to the faster selling vehicles. […] everyone is showing high margins. We didn't all of a sudden get that much better, it's simplistically supply and demand. There is that point where you're missing a lot of sales because you just don't have the inventory. […] the industry performs well and stability exist when there's probably a 60 to 70 days supply in the market. And right now with all the government spending that's going on and people coming out, the demand is going to be high right now, and the fear is the inventory won't be there to match the demand.” -David Hult, CEO, Asbury Automotive Group“As of the end of the quarter, we had a 41-day supply of new vehicle inventory, indicating we have well over a month's supply of vehicles on the ground and an adequate supply of in-transit that are replenishing our on-ground inventory every day.  However, new vehicle margins may remain elevated in the near term due to continued microchip and other supply chain shortages, coupled with elevated consumer demand levels driven by additional stimulus funds. While select OEMs are experiencing reduced level of inventory, we currently have sufficient inventory to balance the current supply and demand trends expected over the coming months.” – Christopher Holzshu, President, and CEO, Lithia Motors“There is no question that there is more demand than supply, that is the headline.  On the new vehicle side, there supply is tight, but shipments and production are disrupted with the chip crisis and will be for the rest of the year.  But it's nothing like a year ago during the pandemic when we had the factory shutdowns. […] we've adjusted pricing to reflect that, and you've seen the improvement in our front-end gross. […] There is no reason to rush things out the door.  You can’t easily replace it.” - Mike Jackson, Chairman & CEO, AutoNation“I've been amazed in the recent months, how we've continued to maintain pretty impressive sales levels with declining inventory levels. […] Also, the OEMs have adjusted. It seems that the only vehicles they're making are the ones that sell the fastest. So when they come off the truck, they go right to a retail customer. […] we're getting to the point where inventory is a problem, if not at this moment very soon. So ideal for us is about 45 days supply when we mix all of our different brands together. And as you saw, we ended the quarter at little over 30. And we're actually fine in the 30s. But we're a big truck market. When you get very far below 30 days of supply, you have trouble having many of the configurations that the truck customers want. And so that's where it starts to get a little challenging for some of our brands.” - Earl Hesterberg, President and CEO, Group 1 AutomotiveTheme 2: Service and parts continue to lag vehicle sales for many dealers, though those struggling for inventory are relying more on fixed ops. While a return to “normal” levels of miles driven should increase service demand, opinions among public dealers were mixed as to the degree there was pent-up demand from consumers deferring maintenance during the pandemic.“Obviously pent-up demand is a big driver. And we are starting to see that coming out of March where we actually started to finally see some real big volume increases year-over-year were great, but what we're really trying to do is figure out when will we start to get to a normalized recovery over what was really the 2019 kind of year, if we use that as a base case. And in the quarter, we saw ourselves about 5% up over that 2019 level. And prior to the pandemic last year, we were projecting a double-digit -- a low double-digit increase in our parts and service business. So we definitely see that trend continuing into April and we expect that to continue through the summer months as we kind of rally into customers coming -- normalizing their lives again and getting back on the road and driving their vehicles and then needing parts and service work.” – Christopher Holzshu, President, and CEO, Lithia Motors“We expect good things out of parts and service for the rest of the year. We see the traffic counts building. Our gross for RO is quite good as we've made some adjustments during the pandemic on that better inspections, better reporting, better selling skills with customers. And we we've added over 300 technicians back to our dealership base in the last 12 months. Very few hourly technicians, which tend to be less productive than flat rate technicians, and that helps us be more productive as a business. And we expect good things as miles driven continue to increase. And if vehicle supplies do become an issue, people will hold on to their cars and they will be in our shops more. […] The customer pay business is extremely strong […] but warranty we don’t control, and warranty has been a bit weak. […] it’s been collision and warranty, which had been soft over recent quarters.” - Earl Hesterberg, President and CEO, Group 1 Automotive“Well, there is no question that miles driven have come down […] in January, we were down 16% in parts and service revenue. Now, that’s really swung around. So, people are getting out. […] So, I think we’ve got to look sequentially how we’re going to look from March to April. This year will give us probably a better picture. But, I can say that there is definitely more momentum and more interest in the shop. […] So we still have some real opportunity there and just a matter of getting people out and that's strictly miles driven will drive that.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroup“March came back so strong, it was actually ahead of '19 pace numbers. And as we sit here in April, we're experiencing the same. So, the customers are back on the road, the service business is back. […] while we're feeling it on the variable side with some shortages with inventory, thankfully Parts and Service is picking up on that. […] We think there’s a lot of pent-up demand.” -David Hult, CEO, Asbury Automotive GroupTheme 3: While many dealers tout incremental sales on their online platforms, it’s important to understand which sales replace would-be in-person dealership transactions and which the company would not have been able to achieve, such as sales to customers where the dealer doesn’t have a physical dealership.“97.8% of our Driveway customers during our first quarter were incremental and had never done business with a Lithia dealership before. […] 43% of our [Driveway] sales are out of region and our average shipping distance is 732 miles […] so we're not really getting into that cannibalization of our existing pipeline.” -Bryan DeBoer, President and CEO, Lithia Motors“There is a lot of incremental [online] sales that we would not have received, and I made that comment, because looking at the information we weren't doing business with [those customers] before.” -David Hult, CEO, Asbury Automotive Group“I think that to a certain extent, it's substitutional where people have the opportunity to buy online, delivery at home, come to the dealership. […] we’re really not growing the business at this point incrementally. And I think that’s going to be the true test where we can tell the analysts in the market, we’ve actually grown our overall business by using the online tool.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroupTheme 4: While Lithia at least reports transactions in terms of price to revenue, multiple companies specified they think in terms of EBITDA multiples. While this might not be true for smaller acquirers, it may affirm the reasonableness of correctly applied EBITDA multiples from the publics.“[W]e generally think more about it as a multiple of EBITDA than revenue. And it's kind of in that high single-digit range, and returns are mid-teens.”  - Joe Lower, CFO, AutoNation“[W]hen we evaluate an opportunity, we're looking at EBITDA multiples and then factoring in the synergies we think we can achieve, and then we look at the IRR relative to our cost of capital. And we need to see a margin there to deliver an accretive deal.”  - PJ Guido, CFO, Asbury Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

2017 Tax Cuts and Jobs ActTo get an idea of how Blue Sky multiples might change with an increase in the corporate tax rate, the simplest way may be to look at what happened the last time the rate changed. Fortunately for this analysis, we don’t have to go back too far. In December 2017, former President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. Shortly after his inauguration, President Trump indicated a goal of “15 to 20%” for the federal corporate tax rate, down from 35% at the time. Fast forward to September 2017, the Trump administration and congressional Republican leaders announced a tax framework that included a 20% federal corporate tax rate, which eventually settled at 21% when the bill was signed into law on December 22, 2017.On a statutory basis, a dealer structured as a traditional C corporation making $1 million in pre-tax earnings went from net income of $650,000 to $790,000, or an increase in value of 21.5% assuming no change in the P/E multiple. While this generally comports with the returns of the S&P 500 in 2017 (which increased 19.4%), this increase happened gradually over time. While there are many other contributing factors, it is evident in the chart below that the market likely priced in any favorable tax changes gradually throughout the year. Because the market generally trended upwards in 2017, it would be difficult to point to any one period of rapid increase related to optimism surrounding lower corporate taxes. However, because the market has historically trended upwards, it can be more difficult to attribute the rise to specific policies. While this paints with more broader strokes for the market, let’s consider Blue Sky multiples. Blue Sky Multiples Before and After TCJAWhile after-tax earnings likely rose for most dealers due to the tax law change, pre-tax profits by definition would not be impacted. Theoretically as noted above, a buyer should be willing to pay more for a higher return, so the value should increase if earnings go up. With the earnings stream utilized in Blue Sky multiples unchanged, an increase in value should be seen in higher multiples.From Q3 2017 - Q1 2018, there were no changes in the range of multiples for any brands despite the material decrease in corporate tax rates. This begs the question: Why not?If dealership values had increased by 21.5%, the average Blue Sky multiple would have increased from 4.85x in Q3 2017 to 5.89x in Q4 2017. This change also could have been more gradual throughout the year. However, multiples were largely unchanged.From Q1 2017 to Q1 2018, only five brands saw a change in their Blue Sky multiples. Subaru multiples improved by one full turn of pre-tax profits in Q2 2017 (from 4x-5x to 5x-6x), while Toyota, Honda, Chevrolet, and Buick-GMC saw more modest increases in Q3 2017. From then until Q1 2018, there were no changes in the range of multiples for any brands despite this material decrease in corporate tax rates. This begs the question: Why not? Well, there are numerous potential reasons.State of the IndustryIn the Q4 2017 Haig Report, private dealership values were judged to have fallen by an estimated 2.6% from the year-end 2016 due to increased expenses. Despite generally favorable macroeconomic conditions in the U.S., auto sales and gross profit per vehicle retailed were starting to trend down at the same time that dealership expenses are increasing, reducing profits. With years of annual volumes above 17 million, there were concerns about declines. While volumes in 2018 and 2019 were below the 2016 peak, they remained above 17 million. SAAR for 2015 through 2019 is shown in the below graph for perspective. As the pandemic reminded us all, volumes do not directly correlate with profits. In order to gain a broader perspective of the auto dealer market conditions, we’ve considered the stock price returns of the S&P 500, the Russell 2000, and the publicly traded franchised dealers in 2017. The S&P 500 paced the group with the aforementioned 19.4% return. Lithia was just behind at 17.3% as it continued to buy up dealerships which the market viewed favorably. The return on the Russell 2000 was 13.1%, well above all other auto dealer stock prices whose returns ranged from 5.5% (AutoNation) to negative 19.4% (Sonic). The trend was particularly bad through the end of August with all non-Lithia dealers down between 6.7% and 23.0%. SAAR followed this general trajectory and caught a nice bounce in September, which coupled with optimism over favorable tax treatment potentially aiding in the rebound. Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset gains, leading to minimal change in Blue Sky multiplesAfter the passage of the tax law and with some time to analyze any impacts, the Q1 2018 Haig Report noted positive and negative trends thusly:Positive Trends: “This remarkable era in auto retailing continues. We have enjoyed many years of low interest rates, cheap gas, and rising employment. Consumer confidence remains near its 17-year high and household wealth has never been greater. It’s true that dealership profits (and values) peaked a couple of years ago, but they remain close to record levels. The much-predicted downturn in sales has not yet happened. Congress even gave dealers a nice boost by lowering taxes and walking back pressure from the CFPB. Negative Trends: "While sales remain strong, there are some troubling vibrations coming from the disruptive influences of technology. Dealers continue to suffer from the degradation of gross profits due to the shift in pricing power from the retailer to the consumer thanks to various digital tools. And over the next five to ten years, electrification, ride sharing and autonomous vehicles loom as threats. Some well-respected industry leaders predict that the best days of auto retail are behind us, that profits will never return to current levels and that many dealerships will end up closing their doors.”Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset these gains, leading to minimal change in Blue Sky multiples. To take the analysis a step further, we consider the specific tax structures of privately held dealerships and transaction considerations, rather than comparing it solely to publicly traded companies which are required to be structured as C corporations.Tax Structure of Largest Auto GroupsBlue Sky multiples are calculated on adjusted pre-tax profits. This enables comparison between dealerships subject to different income tax rates. Differences in total corporate income taxes paid are usually due to two reasons: state/local tax rates and ownership structure (C corporation vs pass-through). First, let’s address state/local tax rates. Language in the Haig report from editions before and after the tax law change note, “dealerships in states with no income tax usually bring premiums to dealerships in high tax states.” This means that for a given range, say 5x-6x, dealerships subject to lower taxes are more likely to receive a pre-tax multiple on the upper end of the range. While not all dealerships necessarily fit into this range, one can infer that local tax rate differences may not ultimately impact the multiple by more than one turn of pre-tax earnings.Dealerships in states with no income tax usually bring premiums to dealerships in high tax statesMany dealers may also structure their companies to be taxed at individual rates (S corporation, LLC, etc.) instead of corporate rates (C corporation). The pass-through tax structure has been popular because it avoids “double taxation” when a dealer pays corporate income taxes on profits then taxes on distributions from net income to dealers after the payment of corporate taxes. For a pass-through dealer, their marginal tax rates only declined from 39.6% to 37.0%. While the initial tax framework proposed by Republicans included a maximum 25% rate on pass-throughs, the TCJA instead offered a 20% deduction for Qualified Business Income (“QBI”). For dealers in the top marginal income tax bracket, this could mean a pass-through rate as low as 29.6% (37% x [1-20%]). Implied increases in values are demonstrated below: As noted above, Blue Sky multiples derived from private dealership transactions are applied to pre-tax earnings, enabling comparisons regardless of elected corporate structure. This is intuitive because a buyer is unlikely to be concerned with the corporate structure of the seller. While corporate taxes declined, many dealerships are structured in this way. Therefore, a negotiation between a buyer and seller is likely to balance favorable income tax treatment against other factors on pre-tax income. As discussed above, industry conditions were relatively stable if not modestly declining. Anticipated Impact of Increasing Corporate Tax RatesUnder the Biden plan, a 28% corporate tax rate would decrease after-tax earnings for C corporations by 8.9% all else equal. However, as we saw after the TCJA, not all else is equal. The reverse may be occurring in 2021 with rising taxes being offset by more favorable industry conditions as many auto dealers finished 2020 with record profits despite a global pandemic.In 2021, rising taxes may be offset by more favorable industry conditionsHeading into 2021, looming threats associated with scale continue to exist, though this is not exclusive to smaller dealers. With online-only used retailers attracting plenty of equity capital from the public markets, larger players in the industry are feeling the pressure to grow themselves. This levels the playing field as buyers are equally incentivized to grow as sellers might be to capitalize on high exit multiples, forgoing the need to make significant technological investments.ConclusionSo, what does the TCJA tell us about the proposed increase in corporate tax rates under the Biden administration? The short answer is it depends. Buyers and sellers are likely more focused on determining the run-rate, or core earnings of dealerships after record profits in 2020 than what rate may or may not apply to them. Fear of rising taxes may motivate sellers to cash in, which would weigh on value if there’s excess supply of dealerships for buyers to choose from. In 2017, the opposite was likely true as bolt-on acquisitions became more costly as dealers were less motivated to cash out as more income fell to their bottom line. As we’ve demonstrated, an increasing federal corporate tax rate may impact some dealers, but for most that are structured as pass-through entities, changes in the top marginal tax bracket for individuals is more likely to impact dealer principals. And while the corporate income tax rate is important for the future earnings of a dealership, sellers are likely to be more concerned about the taxes they would need to pay after selling their business.Mercer Capital provides business valuation and financial advisory services that consider the potential valuation implications of changes in legislation and how this impacts auto dealerships and their principals. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Multiples and Methodologies Moved Considerably Through 2020Prior to the tumultuous 2020, Blue Sky multiples for many brands could be relatively stable over numerous quarters. As seen in later charts, multiples don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM. However, the Covid-19 pandemic increased volatility in the economy to such a level that Blue Sky multiples reacted in a similar fashion regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the next year. Throughout most of 2020, Haig’s reported Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Now into 2021, Haig reports that buyers are using a three-year average of adjusted profits from 2018 through 2020 as the best prediction of future profits. This comports better with the approach taken by Mercer Capital. Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Dealers will likely need to ramp back up staffing levels and advertising to support sales, but strong demand relative to constrained supply has led to higher gross profits for dealers. While dealers are optimistic that the cost savings will be “sticky,” we note ten years of slow, consistent growth since the Great Recession led dealers to such an environment where there were excesses that could be cut out of the cost structure. We see earnings and sales levels normalizing which only bolsters the need to consider earnings in a multi-period context.Illustrative Example: LexusTo show the variance in Blue Sky values in 2020, we’re going to take pre-tax earnings for average luxury dealerships as reported by NADA and apply them to the appropriate multiple. Since Lexus was one of the largest movers and has the widest range, we’re cherry picking them as the best illustrative example.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 6.5x to 8.0x for Lexus dealerships. With 2019 pre-tax earnings of $2.2 million for the average luxury dealership, implied Blue Sky value for the average franchise would range between $14.5 million and $17.9 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $13.4 million to $16.7 million. By Q4 2020, multiples and earnings each increased significantly, and Lexus was up to a range of 8.0x to 10.0x as seen on the below graph. We note the range for Lexus dealerships has widened to two full turns of pre-tax earnings, or rather, two full years of profits. Applied to the three year average pre-tax earnings of the average luxury dealership, the difference in an 8x or 10x multiple represents a $5.3 million difference. High end multiple dealerships would have seen a value increase of $9.6 million ($16.7 million to $26.3 million) in that time, or 57.3%. While this appears high and all dealerships have their own unique characteristics, for context, the S&P 500 index was up 45.3% from March 31 to December 31. Without any context on the reported multiples (the red and green lines above), one might think that values were stagnant in Q4. However, the multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings. For the average luxury dealership, 2019 pre-tax earnings were $2.2 million, which were below 2018. Factoring in the higher earnings of $3.4 million in 2020, the 3-year average is $2.6 million. So, as seen on the graph, a dealership on the top end of the range saw their value increase by approximately $4 million as higher earnings are applied to multiples that held firm. Multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings.Deal Activity Can be Positively Correlated to MultiplesA multiple is a function of risk and growth, and certainly the outlook in March 2020 was higher risk than in in quarters prior to the pandemic. However, as seen below, very few transactions actually occurred during the initial economic decline as sellers were less interested in disposing of their most valuable asset at bargain prices. We note deal activity in 2020 was positively correlated with multiples, which makes intuitive sense and indicates a seller’s market in the back half of the year.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.  Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations partially recovered in Q2. With reduced uncertainty and higher profits, every brand except Volvo and VW received a higher blue sky multiple in Q3 2020 than Q4 2019 (pre-pandemic). In Q4 2020, the only multiple range that changed was that for Toyota which crept into the lead for mid-line imports.Luxury BrandsLuxury Blue Sky multiples followed the overall trend described above with drops in Q1, partial rebounds in Q2, then improved multiples in Q3, all relative to Q4 2019 multiples and earnings. Lexus saw the highest increase, from 6.0-7.5x in Q1 2020 to 8-10x in Q4. On the other end of the spectrum, Infiniti, Cadillac, and Lincoln continue to languish as brands without multiples, commanding a Blue Sky value range of up to $1.5 million. Each of these brands suffers from a myriad of issues, including costly facility upgrade requirements, which tend to weigh on Blue Sky values.Mid-Line Import BrandsMid-Line Imports multiples also followed the overall trend, as only VW’s Q4 wasn’t higher in 2020 than 2019 (each 3.0x – 4.0x). Nissan’s Blue Sky multiple in Q1 2020 declined to a paltry 1.5x on the low end, the lowest ever reported by Haig for any brand dating back to 2013. This was driven by troubles that began before the pandemic as corporate turmoil and an aging lineup weighed on dealer profits. At Q4 2020, this had rebounded to 3.0x – 4.0x, the highest for the brand since Q2 2018. Dealers that held on during the last few years have been rewarded. As noted previously, at the top end of mid-line imports, Toyota snuck its nose ahead of Honda, to pace the segment at 6.25x – 7.25x, on par with Jaguar/Land-Rover and Audi. Q2 and Q4 2020 were the only two quarters on record in which Toyota dealers have outpaced Honda, albeit only at a quarter turn multiple difference. Meanwhile, Subaru has caught up to Honda at 6.0x – 7.0x, a gap that has steadily narrowed since Subaru was closer to a 4.0x-5.0x multiple in 2016.Domestic BrandsDomestic franchises continue to move largely in lockstep with each other as Buick-GMC remains just below the others who command a 3.5x to 4.5x multiple. Domestics continue to outpace many of the mid-line imports, reminding everyone that vehicle pricing power is not the sole consideration in these multiples. Luxury vehicles frequently receive the highest multiples. However, three luxury brands continue to not even receive a multiple while Volvo and Acura are on par or below their domestic counterparts.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership and its corresponding franchise rights. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Fourth quarter earnings calls started similarly to the previous quarter, with significant increases in earnings per share as lower volumes were supported by higher margins and SG&A expense reductions related to personnel and ad spend continue to benefit dealers. Executives generally believe a portion, though not all, of this expense savings will be sustainable. Productivity has increased as employment levels have remained low despite improving activity.Long-term, however, low headcount and insufficient ad spend maybe a drag on incremental sales.February 2021 SAAR was already anticipated to be down from February 2020. February 2020 was the last month prior to the pandemic, did not have supply constraints related to chip shortages, and had a leap day fall on a Saturday.To compound problems, winter storms in certain areas of the country kept more people at home than mask mandates have in recent months. Most earnings calls occurred before the storms or there was little mention of them. AutoNation referenced January volumes in line with projections, affirming their forecast of approximately 16 million for 2021, though there was no discussion of the impact of the winter weather. Sonic indicated the storms closed some stores in their Texas, Birmingham, and Nashville markets, though they anticipate a quick rebound. Total volumes were down 12.6% in February 2021, but declines were closer to 5% after adjusting for selling days. However, we expect to see significant year-over-year improvements as we reach the one-year milestone of the pandemic.The proliferation of SPACs in 2020 and continuing into 2021 has been an interesting byproduct of the pandemic. While this has typically been for more speculative operations including EV startups, an article from Automotive News indicates some franchised dealers are mulling the possibility of accessing public capital markets through a SPAC. LMP Automotive, an ecommerce and facilities-based auto retailer already traded on the NASDAQ, closed on its first wave of auto dealerships on Friday, bringing the publicly traded group to seven. With these acquisitions, LMP will be considered in future earnings calls blogs.On the other hand, the number of public players could well decrease in 2021 as Lithia indicated consolidation amongst the public players may be the best way to ward off competition from used-only players like Carvana. Franchise agreements have long been seen as a hurdle for such significant consolidation, which was downplayed by Lithia. This prompted the question on future calls, and while many anticipate continued consolidation within the industry, Group 1 expressed doubts OEMs would approve such a deal, and AutoNation flat out rejected the notion as they are already the largest public auto dealer.Theme 1: Microchip shortages represent the latest hiccup in dealers’ quest to restore inventory levelsWe sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupWe're quite inventory constrained right now. As you know and we expect the new car inventory situation to continue to be constrained for probably the first half of the year. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveNew vehicle inventory levels remain constrained and we expect demand to exceed supply for an extended period. Given these dynamics, we remain focused on optimizing our business in the current operating environment. We expect industry sales to approach 16 million in 2021 with strong retail sales growth compared to last year. We have seen a solid growth in ‘21, with January trends in line with our annual forecast. - Mike Jackson, Chairman & CEO, AutoNationTheme 2: SG&A to gross profit anticipated to be structurally lower going forward after efficiencies gained during the pandemicSo we have to be below 70% [SG&A as a % of gross profit]. I think to be competitive. I think the world's moved on. So, yes so certainly we would expect to be significantly below a 70% level. As we've mentioned previously, although we do not expect this level to be sustainable, we do expect there to be significant improvement going forward versus pre-COVID levels. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveDuring 2020, we took targeted measures to improve operating efficiencies and manage expense throughout our entire organization, fundamentally improving our cost structure. As a result, we achieved all-time record adjusted SG&A expenses as a percentage of gross profit of 68.1% for the fourth quarter of 2020, down 560 basis points from 73.7% in the fourth quarter of 2019. Full year 2020 adjusted SG&A expenses as a percentage of gross profit were 72.9%, 400 basis points better than 2019. For 2021, we expect to continue to see a benefit of our permanent SG&A reductions. - Jeff Dyke, President, Sonic AutomotiveSG&A expense as a percentage of gross profit declined 940 basis points to 69.7% and declined 800 basis points on an adjusted basis to 71.1%. Our success in this area can be attributed to a reduction in T&E, advertising, vehicle maintenance, administrative, personnel and other fixed costs. We estimate that approximately 125 million to 150 million in SG&A costs have been eliminated across our various businesses. - Roger Penske, Chairman & CEO, Penske Automotive GroupWe also remain very active in managing expenses and we achieved SG&A as a percentage of gross profit of 61.4%. Our focus on gross profit and expense management once again produced a great quarter. […] We also changed our production per employee when the downturn hit, and we stayed disciplined with that. […] I think we'll certainly be in a much better position from an SG&A standpoint than we were pre-COVID. But where exactly […] I think there's too many variables to call that right now. “We sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupTheme 3: Lithia suggests public consolidation may be beneficial for entrenched franchised players seeking to ward off competition from rapidly growing used competitors. While other players doubt the likelihood of OEM support, industry-wide consolidation is anticipated to continueWe do believe that the best way to combat the entire industry is that the public should roll up, okay? And whether or not that can or can happen, we will tell you this, it's not restricted from framework agreements. We believe that we have strong relationships, and our national limitations in those 3 or 4 manufacturers that do have a ceiling established doesn't preclude us from buying any of the other public or joining forces. I do also like the fact that many of them appear to be replicating some of the strategies that we've been focused on over the last 3 years. And we're pleased to see that because I believe that the new car retailers, if we can cut off the stream of used vehicles to the used car new entrants in the space, and all they can really get is auction cars or late-model cars, the margins that we can make in the over 3- year-old cars are massive that the new car dealers could have a stronghold on the space for decades to come, even if electrification changes thing or connectivity or all the other things that are in all – in the back of all of our minds over the coming quarters, years and decades. - Bryan DeBoer, President, and CEO, Lithia MotorsI think there is a natural consolidation that needs to occur among the U.S. auto retail networks. There are simply too many dealers in many of the brands, not all of them, many of the brands to operate in efficient privately owned distribution network. […] And it's becoming more and more a big player game just because of capital investment and amortizing technology costs and the cost of developing people and things like that. So, I think that trend accelerates and that is the reason that there will be a lot of acquisition opportunities as they have been in the past few years […] And I think that will benefit the remaining larger retail groups. And I think it will benefit the OEMs. And so I think there, we're going to continue to move to an era of bigger partners for the OEMs. And - so I think that is very much a catalyst for these M&A opportunities. Now, the advantages of scale you know it would seem that we're not nearly as big as many other groups, yet we've been able to create a cost structure that's just about as competitive as any. So there is a diminishing point of return on scale, I think but there is a benefit to diversity of markets and brands that we can continue to benefit from. And there is potentially a widening of the gap between the ability to operate efficiently - for a smaller operator compared to a bigger operator. - Earl Hesterberg, President and CEO, Group 1 AutomotiveWhat I have experienced is that when you become as large as we are and you make an acquisition, takes a brand Z and you already own 25 brand Z stores and you want to buy number 26 and number 27, and the negotiation with the manufacturer, they will ask, okay, we will improve number 26 and number 27, but let me tell you what you have to do from store one through 25in order to get approval for the next increment. And if you really add that demand on to what you are acquiring, it really changes the return on investment and so the higher you climb the mountain the more difficult it becomes to keep climbing. […] So, the whole issue of consolidation whether two smaller public traded companies could come together, I can’t say, because I don’t have one of the smaller ones. But I can tell you as far as us acquiring one. I don’t see that’s just going to happen, because you immediately run into a problem of too much density in a given market that you are going to have to divest a significant part of what you just thought, at least that would be for us. So, overlap and too much density in the given market is a real genuine issue for us and so we will not be acquiring any other publicly traded company. I don’t see it pay off to the finish line. - Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These trends give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

From 1996 to 2002, six new vehicle retailers became publicly traded companies. While these companies have expanded their footprint, there have not been any more publicly traded new vehicle retailers since. Online used vehicle retailers have recently IPO’d and EV startups have used SPACs to come to market during the pandemic, but these are not comparable to privately held franchised dealerships that can sell new vehicles.This is the first in a series of profiles of these six public new vehicle dealerships. The goal of these profiles is to provide a reference point for private dealers.Dealers may benefit in benchmarking to public players, particularly those that are significantly larger with numerous rooftops. Smaller or single point franchises will find better peers in the average information reported by NADA in their dealership financial profiles. Public auto dealers also provide insight as to how the market prices their earnings.We’re starting with Lithia Motors (LAD) because of their targeted annual acquisitions of $3-5 billion in revenue, which will require plenty of deals with private dealerships, representing a potential exit strategy. Lithia has also already reported their 2020 earnings, so the early bird gets the worm.Lithia Motors Locations and BrandsBased in Medford, Oregon, Lithia has over 200 locations throughout the U.S. largely focused on the West Coast, Texas, and the Northeast. Management indicated 100% of consumers in the U.S. were within a 400-mile radius of the company’s fulfillment network, with this density shrinking to 100 miles in the northwest and 200 miles in the Southwest, South Central, and Northeast. According to the Automotive News Top 150, Lithia sold the third most new retail units in 2019 at just over 180 thousand, trailing only AutoNation and Penske Automotive Group. Lithia added seven dealerships in 2019, making it the most acquisitive dealership in the country that year, a trend they carried into 2020 and is anticipated to go forward. As seen in the table below, nearly 45% of Lithia’s revenues in the last quarter came from Toyota, Honda, and Chrysler. While just under 30% of the company’s revenue came from luxury vehicles (8% BMW/Mini), luxury volumes made up only about 22% of unit sales. Lithia is relatively balanced, seemingly agnostic to brand and segment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. With numerous acquisitions and industry-wide improving gross margins in 2020, Lithia’s revenue and gross profit have grown at an annualized rate of 9.2% and 13.7% in the past three years. Lithia’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume-based incentive fees, operating income can be negative for dealers before accounting for these profits. For Lithia, other income (excluding interest expense) amounts to only 7.4% of pre-tax profits due in part to differences in reporting.Implied Blue Sky MultipleIn this blog, we’ve discussed how Blue Sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied Blue Sky multiple investors place on Lithia Motors. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Lithia’s Blue Sky value per share is approximately $228. With pre-tax earnings per share of approximately $26.8, Lithia’s implied Blue Sky multiple is 8.53x. Luxury franchises trade for multiples in this ballpark, but luxury makes up only approximately 30% of Lithia’s sales. For comparison, domestic brands make up a similar percentage for Lithia with multiples closer to 4x. Still, the scale of Lithia’s operations and significant growth profile lend it to higher multiples, and there would certainly be intangible assets other than franchise values. Primary Pitch to Investors: Growth and “Driveway”Seeking to meet the market’s insatiable demand for growth, Lithia unveiled its five year growth plan halfway through 2020. The company is targeting annualized revenue growth of 31% for the next five years with a goal of $50 billion in revenue (from $13 billion in 2020). Lithia describes itself as the largest participant in a fragmented $2 trillion revenue industry, combining both the traditional new franchise retailers and the used-only auto retailers.Lithia has emphasized and invested in its omnichannel efforts called “Driveway.” This is an eCommerce solution the company compares to Carvana and Carmax. Lithia notes a higher gross margin than Carvana, and the company’s long-term strategic advantage lies in the combination of an eCommerce option for consumers supported by a larger network of traditional retail locations, which increases options for online shoppers in adjacent markets. Lithia sources 60% of its inventory from trade-ins, giving it robust offerings in the online used vehicle space.In 2018, Lithia also invested $54 million in a partnership with Shift Technologies, which competes with Driveway, Carvana, Carmax, and Vroom. According to the most recently available filing, Lithia owns 13.8 million shares of Shift, which went public via SPAC in October, worth approximately $140 million based on last close.The company’s recent investor presentation showed the company added $3.5 billion in annualized steady-state revenue, though it does not specify the impact of the pandemic on this estimate. Lithia’s acquisitions also required an intangible investment of 25% of annualized revenues indicating the company may have paid greater Blue Sky values in 2020 as Haig Partners and Kerrigan Advisors each indicated market multiples increased in 2020 despite declining revenues.Seeking to acquire strong brands and grow profits, Lithia highlights five keys when acquiring dealerships:New Vehicle Market Share: Lithia looks to improve dealerships that are underachieving the OEM’s market share performance goals. They target improvement from 75% of the OEM target to 125%.Used Vehicle Units: The company seeks to triple the number of used vehicles sold per store per month.F&I Profit: By focusing on cross-selling F&I, Lithia seeks to improve GPUs from $700 to over $1,450.Service & Parts: Similar to improving market share targets, the company seeks to improve CSI scores. In addition to improving relations with customers, this focus positively influences relationships with manufacturers.SG&A Reduction: Lithia seeks to use its scale to reduce SG&A expense to below 65% from approximately 90% for its targets pre-acquisition. In summation, Lithia aims to improve pre-tax margins of its targets from under 1% of revenues to above 3%. To quote the CEO, Bryan DeBoer, on the recent earnings call, “Lithia’s model has always been to buy value-based investments that underperform.” Targeting dealerships with thin profit margins also allows Lithia to grow revenues and increase its distribution network while potentially reducing the amount of Blue Sky paid. However, as noted in the Haig report, lower margin dealerships can often attain higher Blue Sky multiples, resulting in favorable returns for sellers as well.ConclusionLithia’s aggressive growth strategy may pay off if they don’t overspend on dealerships over the next five years. Depending on which markets they target, they’ll also need to be strategic to avoid cannibalizing their current sales as they expand. Investors may well reward them if they hit their growth targets, but private dealerships also stand to benefit from an aggressive buyer in the market. This will be particularly true if Lithia falls behind its growth targets, as private dealers looking to exit may be able to extract more blue sky value out of the deal. Dealers in markets competing with Lithia may also see a shift in their pricing strategy, as the company touts 43% of its transactions with customers as “negotiation free,” potentially implying more competitive (read: lower) prices.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance and strategic investment initiatives of the public new vehicle retailers gives us insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Coming into 2020, vehicle volumes in the U.S. were anticipated to dip below 17 million light vehicles sold.  The industry had eclipsed this mark in each year since 2014, though 2019 cut it close. Like most industries, automotive retail got off to a strong start in 2020.  While SAAR was just below the 17.0 million mark at 16.9 in January and 16.8 million in February, the boost of a leap year falling on a Saturday had total volumes at just shy of 2.5 million, up 4.5% from 2019.  While dealers were hopeful volumes would remain high, we all know what happened next in March and April, which put to rest any notion of 17 million vehicles sold.  In the U.S., 14.46 million units were sold in 2020 representing a 14.7% decline and the lowest total since 2012. Normalizing only March and April to their 2019 levels, volumes in 2020 would have been 15.7 million, showing nearly half the 2020 decline occurred in just those two months.The decline can also be attributed to a significant reduction in fleet sales as the COVID-19 pandemic’s impact on travel caused several major rental car companies to cancel orders.  In December 2020, monthly retail sales appear to have actually improved 0.5% from 2019, compared to a 33% decline in fleet volumes.  Viewed another way, fleet sales represented only about 14.3% of total volumes in 2020, compared to a 19.6% share in 2019.  We touched on the impact of retail vs total SAAR last month.The pandemic had a material impact on the sales process in March/April and the sales mix from fleet to retail, predictions from before the pandemic about sales volumes weren’t that far off the mark once stay at home orders were relaxed and dealers figured out how to navigate the new protocols. By September, SAAR had returned above 16 million. However, no month in 2020 reached seasonally adjusted volumes of 17 million, a mark reached seven times in 2019 and every month but two in 2018. So, while nobody could have predicted the depths of the pandemic, we see that the initial expectation of a lower run rate may have been correct.Eisenhower once said, “Plans are worthless, but planning is indispensable.” According to Scott Galloway, Professor at NYU Stern School of Business, “the same is true for predictions – they matter for the strategy and data behind them. Predictions are useless, but scenario planning is invaluable.” I find this quote to be even more telling as it appeared in a piece about predictions for 2020, which just about everyone missed.Heading into 2021, we’re going to make some predictions.  While they may or may not prove true in 2021, we believe this exercise is beneficial for auto dealers who should be looking forward to what the year might bring and prepare themselves should these trends materialize.  While nobody could have predicted their need for Clorox and face masks, the pivot to digital offerings and more targeted advertising was already in motion prior to the pandemic.  Intentional planning can help prepare for what lies ahead, whether or not things actually unfold as you project.  It’s the preparation itself that’s meaningful.Inventory Constraints Lessen and Fixed Operations ReturnsThis prediction is based on the trends seen at the end of 2020 continuing through 2021.  As vaccine distribution ramps up, auto manufacturing should continue as well.  The speed of each of these will likely be a significant factor in total volumes in 2021.  Fixed operations, particularly collision, were diminished in 2020 with fewer road miles driven.  Due to inventory constraints and potential affordability concerns, among other reasons, consumers shifted towards used vehicles.  We anticipate normalizing inventories and an improving economy should both tilt the mix back towards more new vehicles.  However, the recent increase in used vehicle sales should increase the average age of vehicles on the road, which tends to spur more business for dealers’ service and parts departments.  Since this is the highest margin business for auto dealers, we see tailwinds in terms of total profitability.  While higher volumes can bring in more bonus money to dealers on the backend, at the end of the day, profitability is what drives value for auto dealers.Crossovers Remain Popular as Low Gas Prices and High EV Battery Costs Don’t Make the Trade-Off Worth It to the Bulk of Consumers, Yet.Pickup trucks accounted for 19.7% of market share, higher than all cars combined (small, midsized, and large) excluding luxury. Combined with crossovers (43.3%), SUVs (8.7%), and vans (4.7%), light trucks accounted for 76.4% of all sales, up from 72.1% in 2019 and 69.2% in 2018.  Larger vehicles have become increasingly popular with consumers, and low gas prices and improved MPGs reduce the costs of the trade-up in size.  Even inventory shortages and reduced incentives haven’t deterred demand in this segment.  Incentives in December 2020 were down 12.7% from 2019, which along with the continued shift to higher priced vehicles, pushed average transaction prices to all-time highs of just over $38 thousand per vehicle.Nearly 96% of vehicles sold in 2020 were gas or diesel-powered, with EVs making up only 1.4% of the market.  While there has been significant investment in this space, and an incoming Democratic administration portends a shift towards sustainable fuels, we do not anticipate this to materially accelerate in 2021.  Instead, most of the EV progress anticipated in 2021 is more likely to be along the lines of infrastructure investment, legislative assistance, and vehicle improvements.  While many manufacturers such as Volvo have made claims their cars will be all-electric by 2030, we see that progress being back-ended.  While Elon Musk claimed EV battery costs could be cut in half, but this will still be years from now.  Ultimately, until the sticker price can meaningfully compete, EV’s won’t reach the majority of consumers.SAAR of 16 Million (Above NADA’s Forecasted Figure of 15.5 Million)NADA is forecasting a SAAR of 15.5 million in 2021, making our prediction slightly on the bullish side. While the industry appears set for a second straight year below 17 million, improved margins could leave dealers with higher gross profits, which would be a welcomed trade in the industry. According to NADA, headwinds for the vehicle market in 2021 include continued increases in COVID-19 cases, which could lead to production disruptions along the vehicle supply chain. They further noted a global shortage of semiconductor microchips used in many facets of auto production and tight inventory on dealer lots, particularly for pickup trucks. Alternatively, tailwinds for 2021 include a potential economic boom in the second half of the year once a coronavirus vaccination is widely available, and Americans return to work from WFH. Auto retailers also stand to benefit if consumers continue to prefer personal vehicle ownership over rideshare services and public transportation. Finally, low interest rates keep cars affordable, and the Fed has indicated it intends to continue to be accommodative, which should support vehicle demand.Conclusion As auto dealers know, SAAR is a decent gauge on the industry, but it tells us very little on its own. While we believe it’s important to track, we recognize the inherent limitations of just volumes. In the proper context of incentive spending, profitability, and other key metrics, SAAR can be helpful. While dealers can see how their volumes compare to wider industry trends, dealers need to focus on the underlying trends within their local markets to contextualize performance to make sure they are staying ahead of the curve.For an in-depth analysis of how your dealership fits in the auto dealer marketplace, contact a member of Mercer Capital’s Auto Dealer team today.

Third quarter earnings calls started with an optimistic tone, with just about every call reporting record earnings despite revenue headwinds. Advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity.  Tight inventories continue to plague new vehicle volumes, which isn’t expected to get better until the turn of the year. To compensate for this volume decline, dealers have strategically priced the models they did have in stock. Executives noted some points in the quarter where certain models were completely out of stock. Trucks and crossovers have been particularly hot, representing over 75% of vehicles sold.Speaking of crossovers, many executives discussed the point of the transaction where consumers cross over from digital to in-person. During significant shelter-in-place restrictions that caused April lows, dealers were thrust into their online strategies and there were many prognostications about the potential long-term impacts. As the pandemic has persisted, consumers appear to have indicated a preference to beginning the process online, but the desire to test drive the vehicle or discuss the financing has limited the amount of fully online transactions.While Carvana is the new kid on the block in terms of public auto retailing, it’s their used-online operations that franchised dealers are looking to mirror. Across many calls, Carvana’s name was invoked as the key comparative tool to measure how digital offerings match up. While executives all project confidence about their used platforms, it appears clear that the well capitalized online used retailer has an advantage in this area. Still, franchised dealers have their own advantages with access to new vehicles and fixed operations.With consumers still spending a significant amount of time in their homes, the collision business has seen an impact as miles driven has decreased. While miles driven would appear to be the most direct indication of demand for autos, interestingly, executives have noted another trend. With the decrease in rental business and ridesharing, it looks like auto retailing may be regaining market share, which would benefit the industry if this trend continues as the number of miles driven rebounds.The recent Hummer EV unveiling also drew the attention of analysts and executives. The consensus was the hype surrounding the relaunch of a brand that was defunct since the financial crisis was a positive sign for GM, and the shift to electrification will continue. However, many noted the importance of quality models in this shift as consumers won’t be willing to pay up for vehicles (or expensive batteries) that don’t stand up on their own just because they’re electric. This is particularly true with low prevailing fuel costs. While the Hummer EV’s price point allows for good margins, it means volumes will be much lower and ultimately will have less of an impact on dealership profitability.Theme 1:Dealers made significant investments in digital offerings to compete under strict stay-at-home orders. As the pandemic persists, executives believe digital will continue to play a role particularly at the beginning of the shopping experience, though it is unlikely car buying moves fully online.[I]n this day and age 95% of the people are looking online first.  – David Hult, CEO, Asbury Automotive Group[I]f a consumer wants to, which is less than 2% of the population right now[,] they can go online, buy a car from end-to-end, no touchpoints […] I think about 15% to 16%, 17% of our customer base right now is completing some percentage of the transaction online before they come to the store to pick it up. […] The consumers are telling us that they want to be able to search our inventory online, but they want to come to a store, sit with an associate that’s got experience dealing with the car that they’re looking at. They want to test drive from a big inventory before they buy a car and make that decision. Our goal in our hybrid approach from A to Z is to allow them, if they want to go A to J or they want to go A to Z, our system is going to allow that to happen.  – Jeff Dyke, President, Sonic AutomotiveAbout 80% of our consumers use digital forms in some way during the process. We actually only sell about 1.5% of our cars today on a truly digital end-to-end type of solution.  – Bryan DeBoer, President, and CEO, Lithia MotorsTheme 2:Demand continues to outstrip supply as manufacturers struggle to get new vehicles to dealers. Consensus appears to be 2021 before this begins to normalize. Tight inventories have led to higher gross margins.We’ve had of course running conversations with the manufacturers since the spring, and every target has been missed. What we’ve been told we would be shipped, it simply did not happen. I don’t see any change in the fourth quarter from what I understand is coming through, and so now we’re into the first quarter, best case. When I see that they’re able to consistently achieve their shipping targets, then we can talk about what you can sell new. The demand is there at retail. I’m not worried about the demand. […] we’ll either get it through the volume or we’ll get it through pricing.  – Mike Jackson, Chairman & CEO, AutoNationAvailability is coming back. I think we’ve got or 1,000 or 1,200 more cars on the ground at this point than we did last month at this time. And that just keeps improving every month. Manufacturing is doing a great job getting inventory back in our hands. The demand is there, and I think we’ll all be back and rolling as we move into the first and second quarter of next year as supplies build. From a used car perspective, […] the supply is endless.  – Jeff Dyke, President, Sonic AutomotiveThe substantial improvements in gross profit of over $1,000 per unit compared to third quarter of 2019 are largely attributed to high level of incentives from our OEM partners and a perceived inventory shortage in the country.  –Bryan DeBoer, Presiden, and CEO, Lithia MotorsOperators are very savvy, when they cannot replace a vehicle. They don't sell it as cheaply. I mean, that's the simple thing. They know whether they can trade with another dealer, and if they can replace it. So that's driving these high margins throughout the industry. And the ramp up in supply from the OEMs has been far below what anyone in our sector would have expected. We're just now starting to receive a few more vehicles and we're retailing every month. But our new vehicle inventory year-over-year, one point drop something like 12,000 units. So we were still nowhere near back to normal levels. And I'm sure, we're not the only one. So while the reduction in margins going forward will be proportionate to the increase in inventory, there still appears to be a long way to go before the industry is back to normal move vehicle and inventory levels.  – Earl Hesterberg, President and CEO, Group 1 AutomotiveAs we sit here today that we’re still benefitting in our GPUs from the lower inventory and we anticipate at this point to benefit throughout the quarter. The virus is starting to heat, but backed up as we all know, assuming factories don't shut down at all, we anticipated some point in the first quarter to get inventory levels somewhat back to normal, and at that point you would assume you would feel it into margins, but we don’t see that happening in Q4.  – David Hult, CEO, Asbury Automotive GroupTheme 3:While working from home has led to a decline in miles driven which has negatively impacted collision, other areas of parts and service have come back. Despite fewer miles driven, some executives also believe there is a structural change in demand wherein consumers want their own vehicles.In our products and service numbers that we disclosed collisions in there. Collision for us is running, for 12% to 15%, back, depending upon the market. So that's pulling back our CP numbers. We've been positive for the last few months in service specifically, as it relates to customer pay in warranty.  – David Hult, CEO, Asbury Automotive GroupI think we got to think a little bit socially what's really happening, with a vehicle market and personal mobility. […] Personal mobility […] should create some more demand and use cars and also new cars now, not high luxury cars. But I mean, cars that we would use on a daily basis if you needed transportation, because I think combined transportation where two or three people are together, whether it's in a transit, public transit, whether it's a rental car, whether it's Uber or Lyft, I think there's some softness in those businesses, which will drive more automotive sales for us both in new and used. So I think these are things that personal use, will be help us drive a bigger part of the share of the auto business in the future. And I could be wrong. But there's definitely a flight to safety.  – Roger Penske, Chairman & CEO, Penske Automotive GroupThere has been a significant shift towards individual mobility as a result of the pandemic and shelter-in-place. This has increased demand across the board from pre-owned through new in every segment. This individual retail demand is lasting and will continue for the next several years.  – Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These give insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

In our quarterly newsletters, we use various data sources to keep tabs on the auto dealer industry. This includes items like SAAR to gauge the health and activity of the industry in terms of volumes. In this post, we discuss other metrics that help us analyze the dealerships we’re engaged to value. The goal of analyzing such metrics is two-fold: we seek to contextualize how the company’s performance compares to peers and whether a dealership is likely to get a higher multiple in the marketplace. We also strive to provide our clients with an in-depth analysis that can be beneficial to the management of their dealership. Understanding value drivers and performance relative to peers helps dealers understand and, hopefully, increase the value of their business. While sources like RMA (defined below) are frequently used in valuations across industries as a starting point, the auto dealer industry has the luxury of having other unique data sources that can provide further insight to our clients. Let’s peel back the onion and drill down into these various data sources.RMA Annual Statement StudiesBeginning on the outer layer of our proverbial onion, one of the base resources employed by appraisers for companies in a variety of industries is the Annual Statement Studies: Financial Ratio Benchmarks, as published by the Risk Management Association. We refer to this information simply as “RMA” for short.This annual study allows users to determine the composition of common sized balance sheets, income statements, and other key financial ratios. Though RMA data was initially published to aid banks in determining the suitability of loans, this information is still helpful in the valuation context because it allows us to gain insight into industry financial trends.RMA data is offered by North American Industry Classification System codes (“NAICS” codes). For auto dealers, there are Retail – New Car Dealers (#441110) and Retail – Used Car Dealers (#441120). As seen in the pictures below, the vast majority of peer information comes from new vehicle dealers with over $25 million in sales. Most auto dealers, whether they have one rooftop or several, tend to fall into the over $25 million category.  In an industry where vehicles retail around $30 thousand, a dealer only needs to sell about 830 vehicles a year to get to $25 million in revenue, and this doesn’t even consider fleet, wholesale, and fixed operations.While we frequently show both new and used vehicle financial ratios from RMA, the data from new dealers is more likely to be appropriate for a typical franchised dealer, even those with material used vehicle operations.As alluded to previously, this data provides common size balance sheet and income statements. For example, RMA data shows inventory comprises about 60% of total assets, while short-term notes payable (the vast majority of which for auto dealers is floor-plant debt) comprise about 52.8%. Many dealers do not fully finance their used vehicles, which likely plays a role in inventory exceeding short-term notes payable in the RMA data. Inventory as a percentage of total assets and inventory turnover can also be used to determine the amount of inventory held by a dealer.These data points can then be applied to the subject company we are valuing to consider how floor plan debt usage may impact liquidity and expenses and whether they are carrying adequate inventory to support sales.RMA data also provides helpful insights into the following metrics:Working capital as a percentage of salesInventory turnoverAverage Days Outstanding (on receivables and payables)Gross and Pre-Tax profit marginsOfficer/director compensation as a % of sales While these metrics are helpful in analyzing dealers, it is critical to use caution when relying on this information. We believe the data works better as a starting place, as the average of 2,000 dealerships is not going to be directly comparable to the dealership in question. Therefore, we find it more helpful as a test of reasonableness than some figure to specifically tether analysis.NADA Dealership Financial ProfilesWhile RMA data is a useful starting point, the auto dealer industry has more directly comparable data available. Peeling back the next layer of the onion, The National Automobile Dealers Association (“NADA”) publishes Dealership Financial Profiles on a monthly basis.Like RMA, data from all types of dealerships is compiled in the “Average Dealership Profile.” For dealers with many rooftops, this may give a good overall perspective. However, when valuing a single point location, Dealership Financial Profiles help us to get even more specific.NADA offers data for domestic, import, luxury, and mass market dealerships. This is helpful because while operations can be substantially similar for different brands of dealerships, margins and profit drivers tend to be different for the various types of dealerships. This enhanced granularity allows for better comparisons than the information provided by RMA, and monthly information is also more helpful than annual studies. However, NADA information focuses primarily on the income statement, with minimal information on the balance sheet available (excluding the net debt-to-equity and current ratio). Sales, gross profit, operating profit, pre-tax profit figures are offered for various types of dealerships as seen below for domestic dealerships. Beyond just margins, NADA data drills down further into the following: Profitability by department (new, used, and fixed operations)New and used retail volumesF&I penetrationAdvertising, rent, floor-plan interest, and SG&A expenses Like the RMA data, strict comparisons should be made with caution. Still, these are very helpful data points that can lead to better discussions with dealer principals, both about the performance of the business and potential normalization adjustments for valuation purposes. For example, dealerships frequently rent their facilities from an entity that owns the property. This entity and the dealership operations frequently have overlapping ownership structures, and this provides another data point to help determine if the company is paying a fair market-based rent. Related parties may also perform certain advertising functions, which by nature have fewer data points to determine whether a company is overpaying or underpaying for these services. As we mentioned above, another advantage of NADA data is the frequency of publication. Monthly information may be subject to seasonal quirks if profitability is stronger during certain months but comparing to prior year periods largely neutralizes this impact. Using more current information is particularly helpful in the dynamic environment we’ve experienced in this pandemic. For example, in the above figure, revenues and gross profit were down for the average dealership through August 2020, but pre-tax profits actually rose as expenses declined more than gross profit. This analysis would not be possible until the following year of RMA studies. Ultimately, NADA data gets to closer comparisons than RMA, but we can still peel back another layer.20 Group DataIn our valuation engagements, we frequently ask for 20 Group data, which is compiled by OEMs and compares dealers to their peers.Unlike NADA data, the peers in a 20 Group statement will be only the same brand, and selected peers will likely be more similar to the subject company in terms of size or geography (or both). As such, this represents the closest comparison possible.Unfortunately, this data is not always available, and as noted in our other sources, we caution against heavy reliance on such information as necessary valuation adjustments are not frequently considered on dealer financial statements, and therefore, will not lead to fool-proof data points upon which to base valuation adjustments.Blue Sky Transactions DataAnother data source frequently considered in transactions of auto dealerships are Blue Sky multiples, as published by Haig Partners and Kerrigan Advisors.Blue Sky multiples offer different perspectives than the above information. These auto dealer focused investment banks publish indications of dealership intangible value they encounter in the transaction space. For valuation purposes, these multiples can be used in conjunction with peer performance to explain the Blue Sky value of a dealership. If a certain branded dealership typically gets a 5-6x Blue Sky multiple, and the dealership is performing better than their peers, all else equal, they may get a multiple at the upper end or even above this range.However, not everything is all equal. You’d pay more for a dealership that delivers consistently strong returns. But how much of the increased value is due to higher earnings and how much is to a higher multiple?If a company is underperforming its peers, but the buyer believes they can improve performance up to peers, a higher value paid on lower historical earnings implies a higher multiple, so even an underperforming dealer might get a higher multiple than a better performing peer.Multiples are based on some indication of value and some indication of earnings; they frequently describe value rather than prescribe value. Stated more simply, a valuation does not simply derive tangible book value and apply the mid-point of the Blue Sky multiple range to pre-tax earnings. A proper valuation will determine the value of the dealership and be able to communicate why the implied Blue Sky value is reasonable within the context of historical and expected earnings and compare this performance to that of its relevant peers.ConclusionIn total, these various sources offer plenty of perspective into the historical performance and expected value in the marketplace for an auto dealership. Each source offers a different type of insight, and each comes with its own strengths and drawbacks. We have summarized data available from RMA and NADA in the following table.For a better understanding of where your dealership stacks up relative to peers and potentially in the marketplace, contact a member of the Mercer Capital Auto Dealer Valuation team today.

Last quarter, we sat down (virtually) with Kevin Nill of Haig Partners to discuss M&A trends in the Auto Dealer Industry. He noted amidst the uncertainty, buyers and sellers were either applying pre-COVID multiples to lower earnings or lower Blue Sky multiples to pre-COVID earnings. Sluggish deal volume continued into Q2 with transactions down 16% compared to 1H 2019, but the pace is picking up.In this post, we review Haig Partners' Q2 report on trends in auto retail and their impact on dealership values. We also look at how Blue Sky multiples have rebounded after declines in Q1. While most brands saw a partial recovery, a return to pre-COVID multiples was largely reserved for brands with the highest multiples in their category (luxury, mid-line import, and domestic).The Haig report succinctly described the landscape thusly:When customers couldn’t come into showrooms, dealers responded by selling vehicles online. When inventory levels for new vehicles fell, dealers focused on used car sales and were able to hold for more gross on both new and used vehicles. While waiting for the recovery, dealers reduced advertising, personnel and floorplan expenses significantly. The pandemic forced dealers to adopt new technologies and leaner business practices sooner than they otherwise might have. The result is that most dealers have become stronger during this time of crisis, not weaker. Investors have noticed. The publicly traded franchised groups have higher values today than before COVID, and we have seen the values of private retailers rebound as well. Dealership buyers are betting that the future of auto retail is bright, even when the lift from trillions of dollars of government stimulus spending wears off.Activity Ground to a Halt, but It’s Picking Back UpAccording to Haig, about 25-30 dealerships have been bought/sold each month on average. While the pandemic curbed activity significantly from March through May, there is evidence of pent up demand. Haig indicated that of the 42 dealerships that transacted in Q2, 33 were sold in June.While transaction activity has largely come from private acquisitions as seen above, our review of public franchised auto dealer earnings calls indicates public acquisitions are likely to pick up. Public companies, such as Lithia and Asbury (with its Park Place acquisition) have increased their appetite for acquisition. In order to compete in a digital world, public franchised dealers are looking to scale their operations. Online-centric competitors such as Carvana and Vroom have experienced rapid growth in recent years, though they are used vehicle dealers and thus uninhibited by franchise agreements. In order to add scale, public franchised dealers will need to leverage their relationships with OEMs and be more pragmatic in their growth. Still, scale is anticipated to benefit these players by spreading digital innovation costs over higher revenues.Advantageous Buying Opportunities Were Somewhat Short-LivedAs we mentioned above, deal activity from March through May was paused for numerous reasons. First, having to perform the due diligence process virtually reduces the likelihood of a transaction between two parties that don’t know each other well, even if both sides were eager to press forward. Widening gaps in valuations between buyers and sellers also made sellers less likely to relinquish their assets in a spiraling economic climate at the onset of the virus. After all, for many families, their auto dealership is the principal asset on the family balance sheet, and owners were wise to hold tight to their assets in a spiraling economic climate.According to Haig, COVID caused buyers to pull offers or demand price concessions amid concerns of earnings stability. However, buyers have come back to the table in recent months as profits have been much stronger than initially anticipated. Haig estimated Blue Sky values declined about 10% from 2019 levels in Q1; this figure ended up being only about a 5% dip in Q2. Kerrigan Advisors, another preeminent investment bank in the auto dealer space, sees Blue Sky values actually up 3.3% in Q2 2020 compared to Q4 2019. We’ll discuss the rebound in valuations in depth below.While SAAR has declined, gross profits (on a per vehicle basis) have improved.We see an interesting parallel in the minds of buyers, both of vehicles and dealerships. While SAAR has declined, gross profits (on a per vehicle basis) have improved. Through July, average new vehicle gross was up 7.8% per vehicle retailed compared to 2019, while used vehicles improved 5.1%. Consumers hoped an economic disruption would create a unique buying opportunity, but a lack of new vehicle inventory and interest rate tailwinds allowed dealers to raise prices. People with the financial wherewithal to purchase a new vehicle amid skyrocketing unemployment early on in the pandemic likely got a good deal, but NADA estimates incentive spending per vehicle declined 17% from April to August.Similarly, dealership buyers that were able to successfully negotiate price concessions on transactions already in progress likely got a good deal with the surprising earnings performance. Through July, average dealer sales were down 13.6% compared to 2019, but pre-tax earnings declined only 4.6%. As noted in The Blue Sky Report for Second Quarter 2020, published by Kerrigan Advisors, average dealership profits rebounded from lows to highs in the span of two months.Deals that were scuttled, delayed, or that didn’t even get off the ground, ultimately, may have benefited the seller that chose not to sell at the April lows. And as one of our colleagues has told me during the sell-side transaction process, every day you don’t sell your business, you are effectively buying it back at its current value in the marketplace. Dealers who chose to “re-buy” their dealership in April will be glad they did.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. The lone exception was Mazda whose multiples actually improved over Q4 2019. This likely has less to do with pandemic mitigation as it does with other recent troubles. While Mazda’s franchise sales fell the least (7% decline) of all the major franchises compared to 1H 2019, this may say more about 2019 performance than it does about pandemic mitigation. Its range of Blue Sky multiples has improved in each of the last two quarters, but Mazda still remains slightly below its range of 3.0x – 3.75x from Q3 2019.In Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.Every other brand declined about a half turn of pre-tax profits in Q1 (e.g. Mercedes-Benz fell from 6.50x – 8.0x in Q4 to 6.0x – 7.50x in Q1). Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations rebounded in Q2. However, only Porsche, Toyota, Ford, and Kia rebounded fully to their Q4 multiple range. Hyundai actually saw a modest uptick on the high end to pull even with Kia at 3.0x – 3.75x compared to 3.0x – 3.50x in Q4 2019.Notably, Porsche, Toyota, and Ford have recently been the leaders of their peer group. No luxury brands besides Porsche saw a full rebound to the top end of the pre-pandemic range. After years of tracking at the exact same range, Toyota stuck its nose in front of Honda, whose range only regained half of its pandemic losses. Similarly, Ford's Blue Sky multiples have moved in lockstep with Chevrolet since Q2 2018. Pre-pandemic declines to Ford's dealer valuations allowed Chevy and FCA to pull in front in Q4 2019. Now, all three of these domestic dealers sit at a 3.0x – 4.0x Blue Sky range with Buick-GMC just slightly behind.ConclusionFortunately, while there is still uncertainty about when the economy will return to “normal,” the auto dealer industry appears to have adapted to the circumstances at hand. Valuations have rebounded as earnings have recovered, and the industry has largely avoided the doomsday scenarios prognosticated in March. Still, not many people would have predicted working from home would remain so prevalent heading into October. As Q3 wraps up, we hope dealers continue to navigate these waters as they continue to re-buy their dealership.Blue Sky multiples provide a useful way to understand the intangible value of a dealership, particularly in a transaction context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to get the ball rolling.

As expected, the COVID-19 pandemic has thrust many dealerships into relying on their digital and omnichannel offerings due to complications arising from stay-at-home orders. Further government restrictions have curbed new vehicle supply as manufacturers have struggled to ramp up supply. Many dealers noted inventory shortages. However, with sales volumes significantly below the 17 million seen over the last several years, both the numerator and denominator of the days of supply statistic are declining.  Lower sales mean lower inventory isn’t a deal breaker; in the short term, limited supply has led to some gross margin improvement.  However, total gross profit is still significantly down due to the lower sales (combination of lower inventory and lower demand). While sales have improved sequentially as restrictions have eased, parts and service (particularly collision) have trailed in their recovery as fewer miles driven has translated into reduced demand. Analysts inquired about the potential for stay-at-home orders to be ramped back up, particularly in large states such as Texas, California, and New York, though executives largely downplayed the likelihood and the impact it would have on their businesses.On Q1 calls, public auto dealer executives played down incremental costs related to digital initiatives and highlighted the reduction in SG&A related to online sales. Specifically, advertising and personnel costs are much lower for digital. In Q2, public auto dealers saw these initiatives come to fruition, and earnings largely beat estimates despite year-over-year revenue declines of 15-35%. Despite the successful cost cutting, executives were quick to point out not all of these cost savings were sustainable.Theme 1: Manufacturer plant closures have caused inventory shortages, but lower sales levels require less inventory. Some dealers noted higher gross margins due to their limited supply, while others highlighted issues sourcing their most popular models.Our second quarter new vehicle volumes declined 28%, and used vehicle volumes were down 14%, the latter of which was caused by inventory shortages. However, gross margin was extremely strong. New vehicle gross profit per unit was up 40% in the quarter. […] we are seeing a bit of an inventory strain in new and used and especially on the new side with some hot models that are typically our volume sellers. -Daryl Kennigham, President of U.S. and Brazilian Operations, Group 1 AutomotiveIt's going to be a tough road for July August September although we are seeing inventories improve. They're just not going to improve rapidly. I would look for October November time frame to get some normalized inventory levels. And the great news is this low supply equals high margin. -Jeff Dyke, President, Sonic AutomotiveWe are clearly constrained in inventory, and that means that for any given customer that comes to the site, the odds of them seeing the car they're looking for is lower, and therefore, your conversion rates will be lower. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaOur day supply was 52, down 34 days from the prior year. These levels are low, because of temporary OEM factory shutdowns. However, we expect the day supply to increase gradually through the summer selling season. -Dan Clara, SVP Operations, Asbury Automotive GroupTheme 2: Service & parts (primarily collision) fared better in April than vehicle sales. As the pandemic persisted, less mileage driven led to decreased demand due to less wear and tear.Collision is really what's taken the big hit for us […] when April really shut down for sales and service, collision was actually okay and then collusion took their hit in May forward. With less people driving on the road there's been less accidents. So collision has been a little bit further behind. -David Hult, CEO, Asbury Automotive GroupThere's just been people driving less mileage. And so our collision business, which isn't a massive part of our business overall. But it's probably the weakest when you look at it year-over-year. -Earl Hesterberg, President & CEO, Group 1 AutomotiveTheme 3: SG&A declined to lows as a percentage of growth for many of the public auto dealers. However, analysts and executives noted these results were unsustainable in the long-term.Store leaders continue to take prudent and decisive cost savings measures and personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions lead to significant sequential improvements throughout the quarter. Same store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. […] for the month of June, our company [SG&A] to gross profit improved to 57.4%, […] significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs. […] Our stores are well aware that their largest SG&A item is personnel. The next one is advertising. […] As we move forward, the target in SG&A gross percentage is 65% which we’ve talked about for years, I think it seems a lot more attainable in the near term. -Chris Holzshu, EVP & COO, Lithia MotorsWe were 64% which I would never [have] thought we'd be in the 60s with SG&A when looking at July 77% last year. […] We see less salespeople necessary to drive the business. The same thing on the fixed side. We're seeing better utilization of our people. […] I think advertising is moving from traditional to obviously online which obviously is less costly. -Roger Penske, Chairman & CEO, Penske Automotive GroupWe drove significant SG&A leverage through extensive cost reduction efforts, including leveraging our digital capabilities to reduce expenses across labor, advertising and discretionary spend. As Mike stated we will continue to maintain a discipline in our cost structure going forward, targeting to continue to operate SG&A as a percentage of gross profit below 69%. […] We were down about 40% in advertising year-over-year. Really driven by the environment and our digital capabilities and being far more efficient. -Joe Lower, CFO, AutoNationTheme 4: Digital innovation requirements loom large for smaller players who lack the scale to make the necessary investments. However, online used vehicle retailers do not have the same issues inherent to new vehicle retailing for traditional franchised players.Suddenly, buying cars online is becoming normalized. This is a big deal. We have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaI think there is a yearning in the pre-owned market for a brand that can be trusted. And scale also brings in the consumers' mind an idea of trust. And if you really have a good experience and you stand behind the product I think that's where the business is going to consolidate around and whether that's Carvana, CarMax, AutoNation, Vroom, I think the big players that are branded are clearly going to take share. It's a share consolidation in a very big ocean. That's how I see it developing. -Mike Jackson, Chairman & CEO, AutoNationIt's getting tougher and tougher for smaller independent dealers to be competitive in a world where the omnichannel and scale really matters so much. -John Rickel, SVP & CFO, Group 1 AutomotiveI know there's a lot of vibe in the market about growth and how big people can get over the years in consolidation in national branding. We have to remember that this is a franchise business. And that there's dealer agreement with every single one of these brands and then there's framework agreements on that. So until those documents materially change, I don't see the massive consolidation […] Once you start having multiple rooftops of any brand beyond your dealer agreement that exists, you have a framework agreement. And within those framework agreements there are limitations and how many you can acquire in an annual season […] And for a company A to buy company B of 40-plus stores overnight would take a significant amount of work with the manufacturers to make that happen and it would be a true test of some documentations that are out there. […] We all have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -David Hult, CEO, Asbury Automotive GroupConclusionDespite public auto dealership's excitement surrounding the addition of online sales and lower SG&A expenses, key questions still remain. First, are the true costs being measured? “Omnichannel” requires both an online and in person presence. Quoting GPUs or SGA as % of gross may become muddled when trying to apportion which line item expenses are stuck in. What’s important to remember is these costs still exist, even if they seem small relative to the potential sales pickup. Digital may be more cost effective, but a full-on shift into digital for auto dealers likely sheds less cost than expected. Unless dealers plan to significantly shift their real estate strategy, it appears there are limits to how much cost can be taken out of overhead, even if advertising and personnel can be more efficient.How long dealerships can keep advertising and personnel costs low also remains to be seen.  In a period of high unemployment, people may be happy to have their jobs. If we forecast out a few years, will people remain as jubilant to continue to do the work previously assigned to more people? Technology should help reduce personnel costs, but we’re simply pointing out there are limits. And on advertising, digital is the cheaper option – for now. Digital advertising is less established but gives more insight into the successful conversion of customers. For example, how are you supposed to know if someone decided to buy because they saw your billboard? In the long-term, this could lead to higher pricing power for digital advertising platforms.Finally, while large auto dealers have the scale to invest in digital platforms, smaller dealerships do not have such luxury. Their digital platforms may be limited to only when consumers looking to buy a specific make or model Google the closest location and head to the dealership or their website for an omnichannel experience. While these platforms may pale in comparison to larger players, it works for now. The question may become whether smaller players are forced to make commensurate digital investments. In the bear case, dealers would look to exit when deal multiples recover. For those with a more bullish view, we tend to agree with comments made by Asbury’s CEO (worth noting Asbury has the fewest dealerships of the publics). Dealerships may not want to overburden themselves with overinvesting in digital initiatives that aren’t being pushed by their OEMs.  While dealers can be prisoners of the moment or attempt to “Keep up with the Joneses”, to use two puns in one sentence, we also caution it could be a risky play for dealers that step out of their lane and look to materially shift their operations online to compete with the well capitalized players in the nascent space.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Last week, we analyzed Asbury Automotive Group’s acquisition of Park Place, a deal scuttled by COVID-19 that came back to life under revised terms. This week, we are moving upstream to look at the merger between Fiat Chrysler (FCA) and Group PSA (manufacturer of Peugeot and Citroen) and observe the new name of the entity, the merits and hurdles of the ongoing deal, and some potential impacts on auto dealers.What’s in a Name?A fresh start with a new name feels reasonable.On July 15th, the name Stellantis was announced, which drew jokes from various people within the industry. The press release indicated the name comes from the Latin verb “stello," meaning to "brighten with stars.” The name will be used exclusively at the Group level, as a corporate brand, with the names and the logos of its constituent brands remaining unchanged. While the change drew some attention, we think it’s largely much ado about nothing. Sure, the press release was filled with a litany of corporate platitudes about how the name “draws inspiration from this new and ambitious alignment of storied automotive brands and strong company cultures …” but overall we think it might be more of a practical choice considering FCA-PSA doesn’t really roll off the tongue. Also considering its 18 brands on a combined basis, the sheer size of the transaction, and many previous corporate name changes, a fresh start with a new name feels reasonable.While Stellantis won’t appear on any of the cars, it’s not the only industry participant to not have one of its brands in the corporate name. GM and Daimler are the other exceptions in the industry whose names go back a lot longer. Every manufacturer besides Tesla makes cars under a brand other than the corporate name (Toyota makes Lexus, Volkswagen makes Audis, etc.).The company includes manufacturers in Detroit, Paris, Turin, Charlton, Russelsheim, and more. A full list of these brands are included in the graphic below.[caption id="attachment_32791" align="aligncenter" width="642"]*Parts manufacturer[/caption] Merits of the DealHaving exhausted the new name, let’s look at the deal. The deal was announced in October 2019, and in December, Group PSA and FCA released a joint press release highlighting:Benefits of scale in developing more sustainable, tech-savvy (including autonomous) modelsCombined company to be 4th largest global OEM by volume (8.7 million units in 2018) and 3rd largest by revenue (170 billion euros in 2018)Diversification across markets in Europe, North America, and Latin AmericaAnnual run-rate synergies of 3.7 billion euros with no plant closures50/50 merger expected to lead to investment-grade credit rating with high level of liquidity The company indicated 40% of its synergies would come from its combined technology, product, and platform. Stellantis expects another 40% of its synergies to come from sourcing its suppliers at a discounted price due to its bargaining power, or as the company called it, “enhanc[ing] its purchasing performance.” Savings on marketing, IT, G&A, and logistics round out the last 20% of anticipated savings. Mergers frequently try to cut duplicative costs and add to pricing power, both from suppliers and customers. However, since the combining legacy companies largely operate on different continents, minimal enhancements to market share are unlikely to drive higher selling prices to dealers and consumers. This could help enhance blue sky values for FCA dealers, which have lagged other brands.  Enhancements to technology and tweaks to its platform could also help improve the brands’ SSI ratings, which were generally below their respective averages in 2019.Pandemic Impact on the Deal Regulatory HurdlesThe initial press release indicated the deal was expected to take 12-15 months subject to “customary closing conditions, […] and satisfaction of anti-trust and other regulatory requirements.” While the COVID-19 pandemic was certainly not anticipated, the reasons for the deal are “stronger than ever,” according to FCA Chairman John Elkann. Last month, PSA CEO Carlos Tavares also expressed confidence that the $50 billion merger will proceed as planned, noting “the merger with FCA is the best among the solutions to cope with the crisis and its uncertainties.”The deal structure of the Stellantis merger shields it from some inherent issues in acquisitions.While many auto dealers are seeing transactions being placed on pause, the deal structure of the Stellantis merger shields it from some inherent issues in acquisitions. During the pandemic, acquirors are looking to either use a reduced Blue Sky multiple on 2019 earnings or an old multiple on reduced 2020 earnings. This has widened the bid-ask spread, as dealers don’t want to sell at depressed values. With this stock swap merger of equals (“MoE”), each side has to provide equal value to the deal, and pandemic related concerns may cancel each other out. According to Elkann, “both parties in FCA-PSA deal are committed to get parity in the merger deal.” PSA shares are set to be exchanged at a rate of 1.742 shares of the new combined company for each share contributed by FCA. However, it is possible the pandemic has disproportionate impacts on the two companies, requiring a change in the exchange ratio based on adjustments to their relative contributions.There are other issues at play besides the exchange ratio before this deal can be finalized. Both sides have already announced they no longer intend to pay their planned ordinary dividends of 2.2 billion euros for 2019 results which was included in the initial deal. While this is sensible to preserve liquidity in this environment, ordinary dividends aren’t expected to be a sticking point. It’s FCA’s 5.5 billion euros special dividend that may cause problems. According to Tavares, the “time has not come to discuss this issue,” though it is widely speculated that it could be revised downwards in light of the downturn in the global auto industry. This may be a point of contention for FCA shareholders. Peugeot shareholders were also supposed to get PSA’s 46% interest in Faurecia SE in order to help achieve a merger of equals status. This interest was worth approximately 3 billion euros at announcement when the French auto parts company’s shares traded at 50 euros. Shares have declined to about 37 euros (as of July 27th), meaning PSA’s interest is closer to about 2.2 billion euros due to the pandemic.Regulatory HurdlesHaggling between the two companies over the appropriate compensation of this interest and the special dividend isn’t the only hang-up. FCA’s Italian unit had been in talks with Rome over a 6.3 billion euro state-backed loan from Intesa Sanpaolo (Italy’s largest retail bank) to combat the coronavirus crisis. Optically, a special dividend approaching this amount did not sit well, but the loan was ultimately approved. This was the largest crisis loan to a European carmaker. The state support should “preserve and strengthen the Italian automotive supply chain,” according to Economy Minster Roberto Gaultieri. FCA’s COO for Europe said “100% of the money this facility provides will be directed to our Italian business,” though neither side indicated whether any conditions surrounding the special dividend had been imposed.Europe is expected to be the main regulatory roadblock (or maybe more of a speed bump).While the deal has received the green light in the U.S., China, Japan, and Russia, Europe is expected to be the main regulatory roadblock, though executives have categorized it as more of a speed bump.  In addition to earlier concerns in Italy about the special dividend, EU antitrust regulators began its investigation into the deal in June, citing potential to harm competition in small vans in 14 EU countries and Britain. So far, Stellantis has not offered any concessions. According to the European Commission, commercial vans are an “increasingly important market in a digital economy where private consumers rely more than ever on delivery services.” Through a joint venture, FCA and PSA already hold 34% of the van market in Europe. On July 22nd, the European Commission announced its probe had been suspended as the parties failed to provide requested information. The EU was originally supposed to offer its decision in mid-November, which has now been delayed.Will the Deal Happen?Though both sides are confident that the merger will go through as planned, there are clearly some details that will need to be tweaked throughout this process. Merger arbitrage traders usually provide a pretty good real-time view as to the likelihood of a transaction. For example, if a company is to be purchased at $50/share in cash, but shares are trading at $35, that means the market doesn’t think the deal will go through on those terms. However, the market’s view on the success of the FCA-PSA merger is nuanced. Arbitrage traders typically need to be able to short one side of the deal to execute their trade, but France has temporarily banned short-selling. Also, as an MoE, swapping stock certificates means both sides retain equity in the combined company, so share prices give different insight than an acquisition anyway. This means the share prices likely have more to do with the operating environment of the pandemic than the likelihood of the merger, though it may offer hints to what adjustments to the exchange ratio, special dividend, or Faurecia stock may be looming. Because the synergies are centered around cost-cutting measures, and regulatory hurdles don’t appear to be a deal backer, Stellantis will likely come into being if the two sides can hammer out the details.

As we teased last month, Vroom filed an S-1 with the SEC in May enabling its initial public offering (IPO) on June 9th. The online automotive retailer priced the 21,250,000 shares at $22/share. By the end of the trading day, Vroom’s stock had increased 118% to $47.90. For perspective, the NASDAQ as a whole rose only 0.3% that day.The company positions itself as “an innovative, end-to-end platform designed to offer a better way to buy and a better way to sell used vehicles.” A press release also touted its “contact-free” nature, apparently seeking to distinguish Vroom from traditional, franchised, brick-and-mortar dealers as COVID-proof.In this post, we consider Vroom’s business model compared to other online dealers, the company’s investment thesis that may have driven their spike, and see what the filing could tell us about the broader industry and the IPO market more generally.Drafting Behind CarvanaLeading up to an IPO, companies must put their best foot forward and offer plenty of promise. While being a futuristic company that uses buzz words like “data science” and “machine learning” sounds nice, will the benefit of an ecommerce boom ultimately be conferred on Vroom? We’ve previously noted this with Tesla. Despite being the buzz-worthy poster child, Tesla isn’t the only company with online retailing or electric vehicles. Carvana, Vroom’s most direct comparable in terms of online car retailing, IPO’d in 2017 and has about triple the revenue and gross profit margin. Carvana’s public life began with a rather inauspicious start; it opened trading at a 10% discount to its $15 IPO price and finished the day at $11.1 for a 26% decline. However, just over three years later, the stock is now trading 683% above its IPO price (as of June 26th). Carvana rode triple-digit quarterly revenue growth for 23 consecutive quarters, a feat unlikely to be duplicated by Vroom.  However, Vroom is hoping their business model differences will be persuasive to investors.Vroom CFO Dave Jones acknowledges the similarities between the companies from the consumer perspective, but he emphasized their asset-light approach as something that materially distinguishes the two from an investment perspective. This approach has been taken in other industries, and such companies benefit from staying out of the fray when difficult operating environments depress margins. It remains to be seen whether Vroom will be able to navigate this effectively.Investment Thesis from the S-1Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles.While their asset-light approach helps distinguish them from Carvana, Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles. Vroom highlights industry fragmentation (42,000 dealers), millions of peer-to-peer transactions, and dissatisfaction with the status quo as reasons its ecommerce platform can continue to grow. The Company calculates the Used Auto market as the largest consumer product category with $841 billion sales on approximately 40 million units in 2019. This surpasses both Grocery and New Auto sales, which are $683 billion and $636 billion, respectively. Vroom pitches the current used vehicle business model is broken, with “limited selection, lack of transparency, high pressure sales tactics, and inconvenient hours.”Vroom also highlights the gross profit advantages inherent in used vehicles. From 2007 to 2009, the S-1 notes gross margins for new vehicles fell from 6.9% to 6.7%. Not only were gross margins higher for used vehicles, but they actually increased during these troubling times from 8.9% to 9.4%. While careful to explicitly make this forecast, Vroom heavily implies its ability to capitalize on COVID, a story that investors seem to be buying, at least for now.Financial Realities of VroomUnder “Use of Proceeds,” Vroom intends to use the $468 million in fresh capital (excluding certain underwriting costs) for general corporate purposes, including advertising and marketing, technology development, working capital, operating expenses, and capital expenditures. This should help fuel future growth as the company burns cash. Like many companies going public in recent years, Vroom is not turning a profit as it intends to “invest in growth to scale our company responsibility and drive towards profitability.” Advertising expense in 2019 was $72.5 million, which is 6.1% of revenue and more alarmingly, 125% of gross. With advertising consuming only about 40% of its SG&A expense in 2019, Vroom is spending about 3 times gross on SG&A. The company will be hoping that scale will eventually allow them to throttle back advertising spend without giving price concessions on its gross.A red flag for Vroom and its ability to draw future investors is its gross margin. In 2019, gross margin declined to 4.85%, down from 7.11% in 2018. While the company would likely point to its superior ecommerce margins of 6.1%-6.4% over the past two calendar years, it is notable Vroom’s gross margins are well below average margins (11.3%-11.4%) for used vehicle for these years. The asset light approach, one they have used to differentiate, may become a cause for concern as well due to the cost of outsourcing much of its critical operations.Future for Vroom, and Other Auto RetailersWill Vroom be able to carve out a place in the market? There are plenty of examples of duopolies such as Pepsi and Coke, Lyft and Uber, and Republican and Democrat. Uber and Lyft are hot auto-adjacent tech companies, but their service has been commoditized as many of its gig drivers opt to drive for both companies to increase their opportunities for trips and tips. The gig economy has spawned other fast-growing tech companies with many competitors in the food delivery space (DoorDash, Grubhub, Uber Eats, Postmates, etc.). Again, these companies have been forced to compete heavily on price despite not offering all of the same restaurants (not a complete commodity if you want a specific pizza only carried by DoorDash). Consolidation talks have already taken place in this industry, and it begs the question of how online auto-retailing will shake out. There are plenty of examples of tech subsectors having one giant player that is the go-to option for consumers (Amazon for online retail, Google for search engines, etc). Vroom, and the industry more generally, will be hoping that there are many seats at the table. For now, no single party owns more than 2% of the market.How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The S-1 highlighted ecommerce penetration in the industry sitting at just under 1%, compared to about 16% for total retail (thanks, Amazon). Vroom’s long-term value proposition likely hinges on your view of the future of car buying and the Internet’s role in the market. Consumers were forced online during recent stay-at-home orders, but will these necessary precautions breed long-term shifts? How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The ability to seamlessly browse across brands seems appealing, but traditional franchised dealership executives have voiced concerns over how much of the transaction can really take place fully online. Analysts have also frequently questioned the incremental costs associated with delivering cars and whether or not they are covered by the cost savings on retail. With its asset-lite approach, Vroom will provide a good case study.State of the IPO MarketAfter high-profile IPO flops in 2019, including Uber, Lyft, and WeWork (who couldn’t even make it to IPO), the tides appear to have turned in 2020 as exemplified by Vroom and to a lesser extent, Warner Music. Companies such as DoorDash, Lemonade, Airbnb, and others are looking at potential virtual IPOs, which may shed more light on whether Vroom was the anomaly or the precedent.Stock Market VolatilityCOVID-19 has led to significant market volatility with certain industries hammered (cruise lines, restaurants, and airlines to name a few) and others soaring (consumer durables such as cleaning supplies and virtual communication like Slack and Zoom).  Speaking of the latter, a case of mistaken identity sent Zoom Technologies (ticker: ZOOM), a thinly traded Chinese wireless communications company, stock up 47,000%. Investors meant to be investing in the popular Zoom Video Communications (ZM), which has overtaken other platforms such as Skype as the dominant player during stay-at-home orders. Trading was halted to fix this issue, but this has not been the only curious case in the market over the past few months.COVID-19 has led to significant market volatility with certain industries hammered and others soaring.As a further example of the fluid, volatile nature of the current stock market, consider Hertz, the established rental car company. On the same day Vroom was publicly listed, Hertz saw its share price jump to $5.53. Yes, the same Hertz that filed for bankruptcy protection on May 22nd. The pandemic-induced demand shock on car rentals and air travel, that begets more rental cars, compounded years of problems including competition from ride-hailing services. The share price increase represented a nearly 900% rise from a May 27th low and an even more astonishing 80% higher than the day before it filed for bankruptcy protection. The sharp increase prompted Hertz to consider tapping the equity markets for one last bite at the apple. Despite the stock being theoretically worthless, the company was seeking to take advantage of the market’s exuberance after gaining bankruptcy court approval on June 12th. However, Hertz ultimately scuttled these plans as the SEC balked at the company’s filing which included a statement that the company’s shares could “ultimately be worthless.”There are theories abound as to what caused Hertz’ unfathomable increase. Central bank liquidity has no doubt fueled the risk-off mindset as the S&P index has increased nearly 35% since a March 23rd low (as of June 26th). The broader market reversal began when the Fed announced it would be buying individual corporate bonds, a promise they only started to make good on nearly 3 months later. Specific to Hertz, they appear to have benefitted, at least in part, from retail investors bidding up the price. As of June 15, data from Robintrack indicated more than 170 thousand Robinhood users held shares in the company. It was the #1 traded stock on the popular retail investor app that doesn’t charge commissions on trades. Some have taken it a step further to connect it to the dearth of gambling options with professional sports on hold.  A more nuanced view might be that strategic investors are seeking to exploit the structure of the company’s debt. In the past, equity holders threatened to hold up the process, pressuring credit holders to pass on some of the value during bankruptcy proceedings. Hertz’ debt is largely held in asset-back-securities which fragments the voice of creditors and may ultimately weaken their bargaining power. While Hertz and Vroom are on the opposite ends of their time as a public company, each exhibit reasons to be wary of what the market might or might be telling private business owners.ConclusionSo, what does the stock price of Vroom mean for the value of my private dealership? Virtually nothing. While dealerships, like all businesses, require careful analysis in order to determine a reasonable indication of value, the value of your dealership probably did not double in a day. However, the public market does offer the opportunity to gain valuable insights from companies that operate all over the country. Vroom’s S-1 and successful IPO should signal what many dealership owners already know: digital platforms will become increasingly important, inherent margin advantages in used vehicle retailers are attractive, and growth captures the eye of investors.Contact a Mercer Capital professional to discuss the effect the dynamic auto dealership industry is having on your business today.

Auto dealers stock prices declined in the first quarter of 2020 following the broader market trend. Though many dealers saw year-over-year gains in sales and earnings in the first two months of the year, earnings calls focused on the coronavirus pandemic. Volumes have fallen across the country, though executives pointed to recent positive trends. Downturns have muddied the M&A market, and some companies don’t plan to rehire everyone that has been let go. Many praised the support of OEMs including significant incentives such as 0% financing. With dealership doors shuttered, many executives touted their online presence, though there was not a consensus on digital’s long-term place in the market.CarMax (stock price -4% year-to-date May 26th) and Carvana (+48%) have performed better than traditional franchised dealers (-23% on average), pointing to the strength of this business model during this time.  Vroom, Inc., another online used car seller, even filed for an IPO despite the significant macroeconomic headwinds and recent poor performance of auto-adjacent tech-company offerings. If the offering occurs as scheduled and performs well, this bodes well for AutoNation, who owns about 7% of the company after a $50 million investment in late 2018. In mid-April, AutoNation granted its CEO, Cheryl Miller, a leave of absence for health reasons. They also returned their PPP loan well before the Safe Harbor Deadline (most recently postponed to May 18th) due to shifting guidance about eligibility. It should also be pointed out that their eligibility as one of the largest auto dealers in the country drew ire from the public.AutoNation wasn’t the only public auto dealer facing its own issues amid the market turbulence. Asbury scuttled their $1 billion Park Place transaction, which included $10 million in damages, not counting other expenses incurred related to due diligence and financing. This would have been one of the largest transactions in the auto dealer space in years. Penske waited until after their earnings call to announce they were cutting their dividend, “consistent with the other measures the company has implemented the impact of COVID-19.” The S&P 500 has rallied significantly from March lows due to significant liquidity injections and optimism of a quick “V-shaped” recovery, but there may be more room for it to fall if more companies like Penske and Group 1 have to cut dividends.Theme 1: April was the worst month for national sales volumes in decades. However, recovery has been evident on a weekly basis even throughout April as companies ramp up their digital capabilities.In the U.S., our workshops have generally remained open, unlike many of our showrooms, but the flow of service customers has been down 40% to 50% since mid-March, simply because most of our customers have been living under shelter-in-place orders. The closure of most of our U.S. showrooms since mid-March has reduced new and used vehicle sales by a similar percentage. […] As April progressed, we began to see some rebound in our week-over-week sales base in the U.S. market. For the final week, retail unit sales were down approximately 25%, and service revenues were pacing about 30% lower than prior-year levels. -Earl Hesterberg, President and CEO, Group 1 AutomotiveDuring this period, our overall vehicle sales volumes fell roughly 40% compared to the prior year. […] In the past week though, the year-over-year vehicle sales declines have improved to roughly 30%, with used vehicle sales being slightly more resilient than new vehicle sales. Parts and service gross has also improved over the past week as states begin to relax their stay-at-home orders and customers begin to return for delayed repair and maintenance work. -David Bruton Smith, CEO and Director, Sonic AutomotiveTheme 2: Coronavirus has accelerated the push to digital, resulting in heavy investment which means online shopping will continue beyond the pandemic. However, some executives believe consumer preferences and their (lack of) understanding of financing options will continue to be roadblocks to fully online.I think that [digital] trend was already underway where the value of a brand and experience and a warranty/guarantee has all been expressed as a consumer of things that are valued and there’s been a movement towards companies like AutoNation with One Price, CarMax, Vroom, Carvana. […] I think for digital, this whole disruptive period with corona is an inflection point from which there’s no turning back. […]  You need first-class digital capability; you need a safe environment for your customers and a safe environment for your associates. That is the Holy Grail going forward. We see no difference in profitability between the digital channel and the traditional challenge whatsoever. -Michael Jackson, Chairman and CEO, AutoNation[W]e believe that about half of the consumers today would really prefer to be able to buy cars in the comfort of their own home. We are seeing though that there is still many of the consumers and we’ve narrowed it down that we think that about 20% of the consumers have the ability to [complete the car buying process] by doing it digitally and doing it all from home without human interaction. The other 80%, we really believe even though they want to that’s the biggest impediment not the desire, but consumers just don't have the ability. -Bryan DeBoer, President and CEO, Lithia MotorsA lot of customers that come in whether they don't know what they're looking to acquire, they don’t know the kind of vehicle that they want for their family or they have some financial issues. As we’ve said before, you know, our average consumer has $5,100 of negative equity that they’re working to, you know, leverage our finance specialists to help them find the right solutions for them. -Chris Holzshu, EVP and COO, Lithia MotorsTheme 3: Auto dealers cut headcounts to manage SG&A expenses, but not all these jobs will return when markets stabilize due in part to digital. Some are optimistic they will bring everyone back, and most directly relate rehiring to the rate at which business returns.I don't know that [headcount related cost saves are] near-term, I think what we have to do is understand what will be the footprint of our business. How much will be digital? How much will be done from home? How many people we have actually working in the operations? […] As we see the number of people we have furloughed and as a business going [forward will] be decided by how business comes back. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe didn’t furlough any technicians. Because of our cash position and how we manage our expenses [the quarter could have been better] had we just cut the normal expense as you would in a typical recession. We believe that this was going to be temporary. And eventually, the business was going to come back. […] we have strong metrics that will dictate to us when we bring people back. And when we see those metrics starting to be achieved, we’ll certainly bring people back at that time. The folks that we’ve furloughed, we communicate with them consistently, and we were hopeful one day to bring them all back. -David Hult, President and CEO Asbury Automotive GroupWe’ve bought back 1,000 associates thus far, meaning that our staffing reduction is around the same as the business reduction. There is no predetermined cadence or plan as to when we bring back additional employees. […] [I]f I look back to 2008 and 2009, I would observe re-staffing trailed the improvement in business. […] And what other efficiencies and effectiveness around digital is figured out or we come to grips with, whether that leads fact that we hire everyone when we ultimately have a full recovery in our back, well, I can’t answer that today, other than I can say, rehiring will trail the growth of the business. -Michael Jackson, Chairman and CEO, AutoNationTheme 4: M&A has been delayed or canceled due to the coronavirus as buyers aren’t willing to pay what sellers want with earnings deteriorating. Executives believe consolidation will ultimately resume and companies focused on maximizing liquidity may be best positioned for such acquisitions.As we saw business decline, we acted decisively to fortify our business to prepare for the inevitable slowdown. Unfortunately, this included canceling the Park Place acquisition […] we thought the Park Place deal was going to be a transformational deal for us, and it was a heck of an acquisition, but things happen. On the other side of that coin, we’re sitting on a lot of cash and probably the lowest net leverage ratio we’ve had. […] I think we need to see the dust settle a little bit. There is some activity out there. […] I don’t want to comment on [reengaging] the Park Place transaction. But we feel like from a cash position and where we’re sitting operationally, we have the ability to be very flexible and being acquisitive when the right opportunities come. -David Hult, President and CEO Asbury Automotive GroupI think it's going to be brand-by-brand where you have your strengths and also we have scale where you can consolidate some of the fixed costs, but I think it's too soon to look at that. […] We would focus [capital allocation] today, probably investing in the used car business from the superstore perspective and also look at expanding our footprint get on commercial trucks side. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe need to verify earnings quality that they’re within that 90% to 95% earnings level of what they were pre-COVID-19. So, those earnings quality verifications will determine the second half closing date or possibly even beyond that in the event that earnings quality hasn’t improved. There are chances that if earning quality doesn't improve then we would actually renegotiate the transaction in terms of the goodwill amount as well. -Bryan DeBoer, President and CEO, Lithia MotorsOur liquidity position, for us, is about as strong as it's ever been. So as we come out of this, we do believe there's going to be some M&A opportunities for us -Jeff Dyke, President, Sonic AutomotiveSummaryEarnings calls this quarter were uniquely positioned. Despite much of the financial impact occurring in Q2, the demand shock caused by the coronavirus was so severe that many dealers saw a decline in Q1 figures. While things are expected to get worse in Q2, there is optimism as numbers continue to improve on a weekly basis. Still, it should be noted that volumes are becoming less negative, not reversing to positive in most instances. Hopefully trends will continue their positive trajectory by next quarter’s calls. Tough times are ahead for public and private dealers, but current investments in digital strategies may lead to some long-term benefits as a silver lining to this difficult situation.At Mercer Capital, we follow the auto industry closely in order to understand not only recent trends, but how investors ascribe value to the public dealerships. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, reach out to one of us, and we’d be happy to chat via telephone, email, Zoom, or whatever your preferred communication in this dynamic digital age.

Auto dealers are in a unique situation. While technically categorized as consumer “discretionary” items, many people rely on their cars to navigate their busy daily lives. With activity grinding to a halt amidst stay-at-home orders, cars are tipping more towards discretionary items (despite many dealerships being deemed essential businesses).While more practical than other expensive purchases, like a designer handbag, automobiles become less of a priority when budgets are trimmed, particularly when people are staying at home. All told, this will likely lead consumers to delay their purchases of cars, particularly those who want to peruse their options by walking a lot and test driving various makes and models.While other retail industries have fallen prey to the “Amazon effect,” auto dealers have avoided this fate because many consumers are not yet comfortable making such a significant investment without first getting behind the wheel. However, this means sales activity is even more adversely impacted by the current environment. Consumers with disposable income are more likely to spend it on other high-end items that require less personal inspection for style and feel before buying. As we’ll discuss, this is just one of the impacts the coronavirus is having on the auto industry.How Long Will COVID-19 Last?The key questions for auto dealers, and all other business owners, are how long this period will last and how COVID-19 will impact consumer spending on the other side.While lack of wear and tear will delay many timelines, people will still need cars.Buying a car is a significant investment that many consumers will simply delay as staying inside doesn’t require much car travel. In fact, some auto insurers will issue rebates as they expect claims to decline during this period.While lack of wear and tear will delay many timelines, people will still need cars. Significant mileage or a wreck are the most obvious reasons someone would require a new car, but not all purchases are necessitated by the status of a prior vehicle. Getting married, having a child, or turning 16 are life milestones that tend to increase car sales, and these are not necessarily going to be halted by the pandemic. However, if the economic reverberations cause consumers to forego rather than simply delay their automobile purchase as budgets are slashed on the backside of this, a permanent loss in demand would likely prove extremely detrimental to auto dealers.How Will the Auto Industry Respond to COVID-19?While the proliferation of the Internet may not have fully infiltrated the auto dealer business model before the pandemic, the impact of the coronavirus on the way people shop has likely forced dealers to reconsider their digital strategy. Tech-savvy consumers were already using services like TrueCar and Kelley Blue Book to increase price transparency and lower gross margins.  While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.Aside from ramping up web presence, dealers must also consider how they will collectively respond to the reduced demand.Contrast auto to another significantly impacted industry: restaurants. Restaurants can significantly decrease prices in order to keep customers coming through their doors. While they are sacrificing some profits by offering it cheaper, restaurants have plenty of turnover, and customers tend to return to their favorite places frequently. Auto dealers operate differently. Given the relatively long vehicle shelf life, dealers do not frequently experience near-term repeat customers (except for service and maintenance operations).Dealers can get creative with their inventory to get cash infusions, though many will opt to offer increased incentives to boost sales. However, front-loading sales with incentives to make it through the tough times could have negative impacts on industry volumes as well as profits down the road. This pain will be particularly acute if some shoppers accelerate their purchases to take advantage of falling prices when they otherwise may have tried to delay a big expenditure by servicing their aging vehicle instead.Incentive spending hit an all-time peak at $4,800 per vehicle in March, which supported the SAAR (a seasonally adjusted measure of Light-Weight Vehicle Sales) from dropping even further than it did. While annual sales have been above 17 million since 2014, this has included significant increases in incentives which come at the detriment of profitability. Gross profit is a much more relevant metric than revenue in the auto dealer industry, and revenues and volumes propped up by incentives that do not translate to improved gross profits will ultimately hurt dealership valuations as earnings deteriorate.Government ResponseGovernment response to this pandemic has come through both fiscal and monetary policy.  Congress’ efforts on the fiscal side have been more visible, culminating with President Trump signing a $2.2 trillion economic package (the “CARES” Act) into law on March 27. Stimulus checks have started to roll in and the small business loan program, Paycheck Protection Program or “PPP”, has already reached its $349 billion limit. On Thursday, April 24th, Congress passed an additional $484 billion economic package with $320 billion replenishing the PPP, $60 billion in additional SBA disaster relief funds, and $100 billion to support hospitals and increased testing.Government Response Impact on DealershipsMany auto dealers, even those with significant top-line revenues, will qualify for small business grants and forgivable loans. For those on the fence about maintaining their workforce due to sharp decreases in demand for their services, these programs are structured to incentivize dealers to retain their staff.The PPP is likely to boost morale for dealers able to retain their full staff during this time; this also saves future costs of having to train new staff when activity ramps back up. Still, tough decisions will have to be made, and auto dealers may be forced to cut costs they hadn’t considered during the long bull market that categorized the past decade.The auto industry isn’t likely to receive the extensive aid being provided to airlines, but the small business loans won’t be the only impact the CARES Act has on dealerships. The $1,200 payments to consumers are unlikely to motivate people to go out and buy a car, but it could provide enough money to make car payments and get tune-ups or other necessary maintenance.ConclusionAt this point, there are likely more questions than answers. The first order and second order effects of the virus are being measured in real time, and we likely won’t be able to fully understand its impacts until we have the benefit of hindsight. Government responses are likely to continue, though it is unclear the form of future actions.What we do know is that many consumers are staying indoors, and odometers have slowed. Dealers must do what they can to maximize this downtime by increasing their digital presence and managing expenses and working capital. While dealers may need to sell at lower prices, they will have to balance near-term needs with long-term impacts. We have been impressed by the outpouring of support dealers have shown for their communities. We encourage everyone to continue checking in with family, friends, employees, customers, suppliers, and our local communities.

Tesla, the custom luxury and electric vehicle company, has seen significant fluctuations in its share price in the past few months. On October 24th, the Company announced its first quarterly profit (of $143 million) after losing over $1 billion in the first two quarters. It followed this up with $386 million profit in Q4, including a jump in gross margin from 4.1% to 18.8%. If the company can sustain profitability over four quarters (including profitability in Q2 2020), Tesla will meet the minimum criteria to join the S&P 500 Index. It is approximately the 50th largest company in the US (as of March 6, 2020), and after its recent runup and automotive-adjacent Uber Technologies languishing, Tesla is currently by far the largest US company not included in the large-cap index. Should the company’s profitability remain, its share price may elevate even further as investors buy in advance of its addition to the index, a strategy called “index front running.”While Tesla may or may not qualify later in the year, this isn’t the only trading quirk to exogenously impact the company. Share price skyrocketed to $887 at close on February 4th (up 56% in a week and 180% in three months) due in part to a short squeeze where traders faced margin calls and were forced to close their positions at a loss. There are about 18.4 million shares sold short, or about 12.6% of its float (shares outstanding excluding those held by insiders). While Tesla has accumulated a cult following of people both for and against, its share price likely has little to do with the value of franchised dealerships in the US.How is Tesla Different?Tesla has significant differences from dealerships with established brands across the spectrum such as BMW, Toyota, and Ford. These dealerships buy inventory through their auto manufacturers, whereas Tesla uses a direct sales strategy. The dealer franchise strategy has allowed for a large geographic footprint for other manufacturers whereas Tesla has been less able to mass produce. While less ubiquitous, the Tesla brand has benefited from its exclusivity. Further, its direct sales strategy has eliminated any conflict of interest between manufacturer and dealer. One example of this friction is when manufacturers overproduce and push inventory onto the lots of dealers, increasing floor-plan interest costs and oversupply can limit pricing growth.Tesla’s cars are also unique beyond the initial sale. Unlike other cars, Tesla’s cars cannot be fixed by third-party service providers as easily. Whereas a consumer may opt to go a local body shop for their Ford truck, a Tesla owner is more likely to go to a Tesla related service department, which tends to be a higher margin business for dealers. This represents an opportunity for Tesla, provided it can properly address the service needs particularly as its manufacturing operations continue to scale. While not typically viewed as maintenance, Tesla’s power source is also unique. For electric vehicles, consumers can charge their cars at home or at Supercharger stations instead of gas stations. While electric vehicles are viewed as cheaper and more eco-friendly, adoption of EVs relies on an increasing network effect where charging options approach the abundance and accessibility as gas stations.Future of Electric Vehicles (EV)Tesla did not invent the electric vehicle, nor will it appeal to all consumers as electric vehicles have range limitations particularly on road trips. There are also large upfront costs both for the vehicle and in-home charging stations. Further, numerous brands also offer electric vehicles including Kia, Hyundai, Chevy, Nissan, VW, Audi, Jaguar, and BMW, the latter of which just recently released it's latest and greatest. While the EV market is expected to increase over time, Tesla will clearly not be the only benefactor despite its ability to garner headlines, due in part to their enigmatic founder, Elon Musk. The company’s share price may represent a long-term bet on this power source, though Tesla is not likely to harvest all of the benefits. Still, dealerships and more importantly their manufacturers will do well to keep up with shifting consumer preferences including both EVs and the increasingly prevalent SUVs (particularly the cross-over segment).If Not Tesla, Where Do I Look for Valuation Insights for My Dealership?For dealer principals looking to keep up with the current trends, monthly releases of SAAR give an indication of volumes in the US that is frequently quoted as a barometer for the market. However, this does not factor in a variety of considerations including the level of incentives to induce these purchases. Further it tells little to nothing about a dealership’s service department, where a significant portion of gross profit is made. Public auto dealers, such as Auto Nation and Asbury Auto Group, indicate how investors in public equities view dealerships. However, these are limited comparisons for dealerships that are more geographically concentrated, may carry fewer brands, and have limited access to capital markets. Looking at stock prices and valuations like Tesla or other manufacturers such as Ford and GM may give a look into the overall health of the auto sector but will be even more limited for dealers.Transactions tend to be a reliable indication of value as it shows what someone was willing to pay for a dealership, not just a small, non-controlling fraction of it. Resources such as Haig Partners and Kerrigan Advisors publish quarterly indications of Blue Sky (value of a dealership in excess of net asset value, expressed as a multiple of pre-tax earnings) which cull transaction data. While frequently quoted in the industry, it is unlikely that buyers would simply apply such a blue sky multiple without rigorous due diligence to understand the idiosyncratic aspects of cash flow, risk, and growth, inherent in a target dealership.At Mercer Capital, we provide a variety of services for owners of car dealerships and dealer principals. We analyze 13th month dealer financial statements, evaluate facilities (including rent factors, lots, and service bays) and develop independent and reliable valuation appraisals and calculations for a variety of needs and circumstances including buy-sell agreements, litigation, and more. For an understanding in how your dealership is performing along with an indication of what your dealership may be worth, contact a professional at Mercer Capital to discuss your needs in confidence.

In previous posts, we have delineated between royalty trusts and mineral aggregators and discussed the valuation implications of prevailing high dividend yields of public royalty trusts.  Yields remain elevated, and these trusts have declined in their usefulness from a valuation benchmarking perspective. In this post, we focus on mineral aggregators.  We also offer insights on the investment landscape at large and particularly as it relates to the minerals subspace by providing an update on the most recent IPO, Brigham Minerals (MNRL).Market Data for Aggregators and TrustsThe following tables provide some critical market data for valuation purposes. Since our last update, SandRidge Mississippian Trusts I and II (SDT and SDR, respectively) were delisted in mid-November as the stocks fell below $1.00 in May and traded below that mark for six months.  All else equal, public royalty trusts are expected to decline in value as investors get their return almost exclusively from yields because production declines over time. Thus, trusts eventually being delisted is not a surprising outcome due to restrictions on acquiring additional acreage or wells. Given the eponymous operator SandRidge Energy’s struggles, it’s even less surprising these two trusts were delisted.  SandRidge Permian Trust has avoided this fate for the time being, due in part to its attachment to the prolific Permian and sale to Avalon Energy, but the trust has also been put on notice. Unlike public royalty trusts, mineral aggregators are not restricted from acquiring additional interests, which makes them more of a going concern by comparison.  This is among many reasons investors have increasingly turned towards mineral aggregators. Long-time readers of the public mineral interest portion of our blog will note the revamped look at value drivers and key benchmarks for mineral aggregators. Public Markets Unreceptive of Energy SectorThe stock market has been booming over the past decade as the economy has ridden the longest expansion in history.  Investors in the energy sector, however, have not experienced the same joyful ride.  In 1990, energy made up 15% of the S&P 500 sector weightings, but in 2019, that figure was down to 5%.  Ironically, over the same period, the United States’ oil and gas production surpassed all countries and claimed the top of the leaderboard, becoming the world’s largest producer. Depressed commodity prices have also likely aided valuations for companies in other sectors as transportation costs are lower in an increasingly globalized economy with two-day shipping becoming common place.The graph below shows the relationship between the Vanguard Energy ETF, created in 2004, and the SPY Index over a 15-year period.  Slow economic growth coming out of the recession caused Energy to outperform, but commodity price declines in late 2014 began a reversal that has widened since 2017.Energy vs. S&P 500 There are many reasons that this story has unfolded such as diminishing return on investment, fluctuation in commodity prices, and oversupply, but we do not dive into that in this post.  Instead, we want to illustrate the ways in which mineral aggregators have been able to manage some of these issues. Mineral aggregators are constructed to diversify capital among many superior plays and specific operators.  This niche in the energy market allows investors to capitalize on both current yield and capital appreciation with the aggregators’ reinvestment capabilities.  Crucially, royalty holders do not bear operating and drilling costs as these costs are paid by upstream E&P companies.  Brigham Minerals articulates the benefits of the business model as follows: “There are many advantages of the mineral acquisition model, including no development capital expenditures or operating costs, no exposure to fluctuating oilfield service costs and higher margins than E&P operators without associated operational risks.”Mineral aggregators receive a royalty based on revenue and are thus isolated from a number of field-level economic issues. This is not unlike the restaurant industry, where franchisors command a much higher valuation than the operators to whom they franchise.  Declining same-store sales figures in that industry are hurting profitability for operators grappling with the necessity for capital expenditures to fund future growth while those collecting royalties off the top can prosper with their asset-light models.  Sound familiar?Brigham Minerals Seasoned Equity OfferingIn a previous post, we discussed the much-anticipated Brigham Minerals’ IPO in April 2019.  The upsized offering was sparked by higher than expected demand.  Many saw the IPO as an investment opportunity that promoted cash flow, something that operators in the market were not providing.  There was speculation that additional mineral companies would likely IPO over the course of 2019 given the demand for Brigham Minerals, but that turned out not to be the case.  In December of 2019, however, Brigham Minerals announced in an S-1 a seasoned equity offering of 11 million common shares.  The Company offered 6 million new shares of its common stock, and some selling shareholders sold an additional 5 million shares.  Shares were priced at $18.10, likely a psychological threshold, as it was priced just ten cents above the IPO price only eight months prior. Credit Suisse, Goldman Sachs, and RBC Capital Markets acted as lead booking-running managers for the offering, and they were granted a 30-day greenshoe option totaling an additional 1.65 million shares though these were not exercised as the share price remained above the issuance price, averaging $19.70 for the first month of trading. Generally speaking, 2019 was a poor year for IPO’s with ride-share companies Uber and Lyft among the high-profile unicorns that floundered. Peloton opened 6.9% below its trading price and multiple companies, perhaps most notably WeWork, decided to scrap the IPO altogether. Brigham’s IPO success and perhaps more importantly its ability to issue additional equity just eight months later may encourage private equity firms invested in minerals companies to test the IPO market.ConclusionMineral aggregators appear to have supplanted public royalty trusts as a key means for investors to get exposure to the sector while avoiding costly drilling expenses. While functionally related to drilling activity and well performance, aggregators allow investors to avoid cost burdens.  As such, valuations for the aggregators behave differently than other participants in the energy sector.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners.  We have differentiated between mineral aggregators and public royalty trusts and introduced some other considerations for how to pick the appropriate comparable. In this post, we will discuss the prevailing high dividend yields of public royalty trusts. We will also offer some reasons for why these trusts may be declining not just in production but also their comparability, from a valuation perspective, to some privately held mineral interests.Market Data for Trusts and AggregatorsThe following tables gives some critical market data for valuation purposes:We note that the yields are significantly lower for mineral aggregators than the public royalty trusts, who also have significantly lower market caps. Previously, we’ve explained what a royalty trust is; however, to understand these recently elevated yields, we may need to back up and discuss why royalty trusts are started in the first place.Why a Royalty Trust?Royalty trusts represent a unique financing tool for E&P companies. Instead of holding onto wells and collecting revenue over a longer holding period, operators can monetize these wells upfront by selling the wells to a trust. This allows operators to reinvest the proceeds back into its operations in an industry where cash is key. Trust distributions are determined by the level of production of the wells and commodity prices. By selling the wells to a trust, the operator can avoid the need for hedging the price risk. Also, since production of the wells is expected to decline over time, operators can avoid the drawn out, declining marginal utility of the wells. This is particularly helpful considering a dollar today is worth more than a dollar down the road.Potential Pitfalls of Public Dividend Yields as a Proxy for RiskWe’ve discussed the importance of scrutinizing each royalty trust individually in order to determine the comparability with private interests. Some of these considerations include:Commodity mix (oil vs natural gas)Idiosyncratic issues with the operatorRegion/basin However, these are not the only considerations, and they may not provide the proper sanity check in the context of the elevated yields that have persisted in recent months.Some further considerations include:Stage of productionCalculation method of the dividend yieldFriction in equity market pricingOperating Expenses in a depressed commodity price environmentWhere are you on the Production Decline Curve?As oil and gas is extracted from a well, its production declines over time.  As production declines, the yields tend to increase (more on this later). This can misrepresent the risk to reward opportunity as timing must line up.  The value of a mineral interest that has been producing for an extended period of time should not be compared to a well that has just started production or is even still in the drilling or development stage. These situations are two different points on the production curve and represent different risk profiles. For a PDP (proved, developed, producing), there is less risk than any other stage (compared to PUD, P2 or P3). It is important to consider the relationship between these stages of production instead of simply looking to the public markets and being prisoners of the moment or uninformed of the differences between public trusts and a privately held interest. The stage of production and decline rate must reasonably reconcile to private interests to ensure that yields and commensurate risk are compared apples-to-apples.Trusts are frequently prohibited from acquiring additional wells to replace production, unlike E&P companies and mineral aggregators. With production declining, the share price of trust units tends to decline as well, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation. Yield is dividends divided by price, and a declining denominator can lead to higher yields. As production declines, the yields may begin to shift from a reasonable expectation of the risk associated with expected future cash flows to a reflection of the minimal life of the well.Different Dividend Calculations Can Lead to Significantly Different IndicationsThe calculation of dividend yield can also be crucial to understanding risk. Taking the dividends paid in the past year may not be representative of future dividends. While annualizing the most recent dividend may cause issues with seasonality, it may be more appropriate given the commodity price outlook. Annualizing the most recent dividend causes a significant divergence in the implied yield for more than half of the royalty trusts, while the yields change by less than 2% for all of the mineral aggregators.Take Prudhoe Bay (BPT) for example. Its 63% yield as of October 30th includes a $1 dividend per share in January 2019. However, distributions have only been only $1.23 in the next three quarters combined as its 10-K estimated a significantly declining outlook. Annualizing the most recent dividend of 34 cents per share drops the dividend yield closer to 28%, notably lower than 63%. While 28% may seem high even in the context of mature production, current commodity prices indicate the trust may cease payouts after January 2020.  Calculating yields by annualizing more current dividends can help normalize yields to better indicate the underlying value of the trust’s production.Public Equity Markets May Complicate Intrinsic Value of Royalty TrustsIn theory, trading in a public marketplace gives public royalty trusts an indication of market value.  There is friction, however, between the stock market price and the intrinsic value of the trust. It is common for public royalty trusts to have relatively small share prices.  Also, as they age and decline over time, they will become less productive, and investors would be less likely to want to incur the trading costs to build up a position in a stock with little to no residual value. Investing in a small stock creates the need to load up on shares to make a meaningful investment. Doing so, however, can cause the price to move unfavorably. This is particularly the case if the stock is thinly traded.This problem can be compounded by float, that is, the number of shares actually available for trading. As an extreme example, Permianville Royalty Trust (PVL) has just over half of its shares free floating. These issues further complicate the ability to use yields from public royalty trusts as a proxy for risk for private interests.Operating Expenses Become Increasingly ImportantSince royalty trusts are not encumbered with production expenses, trust operating expenses tend to be fixed and minimal. However, revenue tends to be volatile with commodity prices. In the currently depressed commodity price environment, particularly for natural gas, these operating expenses become more pronounced. As we see with the SandRidge Trusts (SDT) (SDR) and ECA Marcellus Trust I (ECT), yields can be higher for trusts with higher operating expenses as a percentage of revenue. Lower prices make the sensitivity to operating expenses more apparent as margins are tighter.ConclusionWhen using it as a pricing benchmark for private royalty interests, there are many reasons to scrutinize the public royalty yields and their comparability. Further analysis is required to ensure these provide meaningful valuation indications.  It is important to assess the implied shelf life of the interest and stage of production. Yield also must be considered both in the context of historical and expected future dividends; they must also consider the equity market ecosystem in which the trusts trade. Lastly, yield and implied risk must consider the prevailing commodity price environment and its impact on royalty trust’s operating expenses.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

While large, rapid commodity price declines are certainly harmful for near-term profits and long-term planning, persistently low prices may be more ominous for industry operators and investors. Prices rebounded from a low of $45/bbl, but crude has been below $60 for nearly 3 months. Natural gas prices have similarly languished, remaining below $2.50/mmbtu in that time. Two Houston-based E&P companies (Halcon & Sanchez) recently filed for Chapter 11 bankruptcy within days of each other, raising questions about the state of the industry. Size and operational efficiency may enable some players to stave off issues, while others may be forced into difficult decisions between preserving capital and investing over budget to produce enough debt-servicing cash flow.Theme 1: Bankruptcies May Return if Prices Remain Low Over the last year, we have taken proactive steps to address the challenging oil and natural gas price environment, including stabilizing our production profile, improving our capital efficiency, and reducing our overall cost structure. Undergoing a financial restructuring through a voluntary process represents the next phase for Sanchez Energy, as we work with our creditors on a plan to right-size our balance sheet, further invest in our assets and generate long-term value for our stakeholders. - Tony Sanchez III, CEO, Sanchez EnergyRagan [incoming CFO] is joining Halcon at a critical time [bankruptcy restructuring] and will help lead our focus on capital discipline, cost control, and strategic plans for developing the Company’s assets to maximize shareholder return. - Rich Little, CEO, Halcon Resources We start with quotes from companies that didn’t actually host earnings calls. Sanchez Energy has been beleaguered for years now, unable to turn a profit since the drop in oil prices. Once the third most active driller in the Eagle Ford, Sanchez filed for Chapter 11 bankruptcy on August 11th. Sanchez’ CEO touches on capital efficiency like many executives in the industry, as we’ll address later. He also harps on generating long-term value for stakeholders, a slight twist on the predictable “providing long-term value to shareholders” due to their debt-laden predicament. Sanchez certainly isn’t alone. Halcon Resources filed for bankruptcy on August 7th. However, the company expects a 60-day turn around, during which it will continue to pay vendors, royalty owners, and others as part of ordinary business through the bankruptcy process, subject to approval from the courts. This is the second time since 2016 that the company has buckled under its debt load. The Sanchez quote came as part of its press release regarding the bankruptcy proceedings, and the Halcon quote addresses the hiring of a new CFO in the wake of its filing. Each CEO outlines a critical issue for industry operators. Large scale, multi-year projects employ debt financing to lower the cost of capital, but too much debt can raise the cost of capital due to the increased risk of making the required payments. Fluctuating commodity prices further hamper the ability of E&P companies to make these payments. When companies are forced to file for Chapter 11 bankruptcy, they are usually able to resume operations, though the shareholders essentially lose all, or a substantial portion, of their investment. Industry operators will hope that these low prices will not persist, or other companies may join Sanchez and Halcon.Theme 2: Size MattersWe have a very large footprint though that allows us to work within certain areas over a vein, within certain areas due to these [Bakken gas processing] constraints. So we are able to work around them. And we have led the industry up there with gas capture we still do. - Harold Hamm, CEO, Continental ResourcesCombining Oxy and Anadarko will create a diverse portfolio of high quality and complementary assets, well suited for our core competencies. As we apply our development approach to the combined portfolio, we expect this to be the low-cost producer in all of the areas we operate. For example, along with the expertise I've already mentioned, we will apply our proprietary drilling process, Oxy drilling dynamics across Anadarko acreage. To date, Oxy drilling dynamics has reduced costs by at least 30% in all of the areas that we've applied it, and we expect to achieve similar results in Anadarko’s onshore and offshore developments. - Vicki Hollub, CEO, Occidental PetroleumOne final point on our pending acquisition of Carrizo and one of the most important aspects of the transaction is the ability to optimize long-term development value of our combined inventory. By merging these two companies we are creating a vehicle that can effectively compete in a lower commodity price environment without the need to high-grade near-term target zones at the expense of other zones that are left behind for less efficient future development after the passage of time. - Joseph Gatto, CEO, Callon Petroleum Size allows companies to achieve scale in their operations, spread expenses over larger amounts of revenue, access capital markets, and even negotiate lower capital costs. Larger E&P companies are typically less at risk of bankruptcy than smaller players in the industry. Chevron began the quarter with its announcement of plans to acquire Anadarko Petroleum, but Occidental stepped up with a larger offer and eventually won the day. While this transaction has stolen the headlines, Callon’s smaller acquisition of Carrizo after quarter-end echoes the trend in the industry. Size allows these companies to achieve synergies, apply techniques to more acreage, and survive in low-price environments.Theme 3: Capital Efficiency to Bridge Gap Between Production Estimates and CapEx BudgetsWe have also achieved the efficiencies throughout the first-half of 2019 that will allow the reduction of drilling rigs from 19 rigs in SCOOP STACK to 12 rigs on early fourth quarter of 2019. […] I am proud that our teams can exceed production estimates with lower rig activity, that is operating and capital efficiency at its best. […] We're very committed to meeting our CapEx and other corporate guidance for the year, and have the flexibility to do so as we're demonstrating. - Harold Hamm, CEO, Continental ResourcesFor two quarters in a row we delivered more oil for less capital. With efficiency gains and new technology, we are achieving strong capital and operating cost reductions, while at the same time delivering excellent well performance. […] Looking ahead to the remainder of 2019, we modestly increased our full year U.S. oil production guidance as a result of better well performance. There is no change to our activity level in 2019. We will remain disciplined and still expect capital expenditures to be within the original range of $6.1 billion and $6.5 billion. - Bill Thomas, Chairman/CEO, EOG ResourcesTowards the end of the quarter, we shifted our focus to the completion of our first Delaware mega pad, which importantly utilized a simultaneous operation of two completion crews to increased efficiency and reduced cash cycle times. As we've emphasized previously, increased use of this model is made possible within a larger entity and is a clear strategic benefit of the Carrizo merger. - Joseph Gatto, CEO, Callon Petroleum Shale oil production has increased output, and U.S. E&P companies have provided much of the supply growth in global production. However, shale’s inherently higher declines rates require more drilling to replace more rapidly declining production, making investors wary to receive their share (dividends) of the returns on these investments. This, in combination with depressed commodity prices at year-end, led to lower capex budgets for 2019. Seeking to keep their promises after blowing through their budgets last year, E&P companies have preached capital efficiency. They tout the operational efficiencies that will allow them to decrease their capital spend to close 2019. These efficiencies are crucial because according to data compiled by Shale Experts (subscription required) in the below table, many E&P companies have already spent over half their budget. There are many factors at play in this number. Capex can and tends to be frontloaded due to seasonal factors. Still, executives will be hoping that their drilling efficiencies are achieved. Some companies may find issues hitting their production targets while decelerating drilling activities. They may be stuck between a rock and a hard place: failing to reach production targets or failing to remain within capex budgets. Theme 4: Parent-Child Problem Continues to Plague OperatorsIn the Delaware Basin, the 23 well Dominator project was designed to test logistical capabilities and well spacing that was approximately 50% tighter than our current resource assessment. While initial rates were solid, current performance data indicates that we developed the Upper Wolfcamp too densely. We're incorporating the data into our development model to adjust spacing on future projects including those projects set to spud in the second half of 2019. -Tim Leach, CEO, Concho ResourcesWe've always been conservative in our spacing assumptions, and we don't really have any plans right now, especially as commodity price continues to decline, to look at any reasons to increase well spacing. This is one of those things where we've been pretty steadfast in our strategic development objectives on spacing. And we would pay attention to other spacing results that go on in the Permian Basin. And we try to learn from those as well too without exposing our shareholders to down spacing risks. -Travis Stice, CEO, Diamondback Energy As we noted earlier, E&P companies are always looking to gain efficiencies. This can come from strategic M&A, contiguous acreage, repeatable drilling methods, and many other sources. However, there are limits. Specifically, well spacing has become increasingly important in the Permian as the parent-child problem continues to plague operators. Stated plainly, the first well drilled in a pad (the “parent”) tends to be the strongest well, getting the most bang for your buck in the reservoir. Subsequent wells drilled in the pad (the “children”) allow for more oil to be harvested quickly but at a decreasing rate per well. Trying to fit more wells onto pads may be more efficient from a drilling standpoint, but geological factors tend to lead to diminishing marginal returns from this approach. As Concho’s CEO admitted at the beginning of the earnings call, their Dominator project was not properly spaced. This news was not well received, as Concho’s stock dropped 22.2% on the day and has slid even further since. It appears Diamondback’s approach to conservative well spacing was well received as its stock increased 2.7% on its announcement and has continued its upward trajectory.ConclusionCommodity price will always be at the forefront of the oil and gas industry. Higher prices allow for more investment, higher profits, and lofty valuations. On the downside, operators must make it through lean times while avoiding bankruptcy. While keeping debtholders happy by making their required payments, they must also seek to please equity investors by achieving production growth on a tight capex budget. Size tends to help both of these as capital becomes cheaper and scale allows for successful drilling techniques from one basin to be applied to operations in other areas.At Mercer Capital, we have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. We can help companies navigating the bankruptcy process, considering M&A in an acquisitive market, or maintaining their operations business as usual. Contact a Mercer Capital professional to discuss your needs in confidence.

In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners.  Here, we will define our group of royalty interests which can be used to gain valuation insights.  Specifically, we will look at mineral aggregators, natural gas focused trusts, and crude oil focused trusts and the statutory differences between them. We also consider how dividend yields and other public data can be used to imply value for private mineral interests while being judicious in our application of such metrics.What is a Royalty Trust?Historically, the most common way mineral interests have been structured for public investment has been in the form of a trust. The trust’s sponsor (frequently though not always the operator) conveys a percentage interest in specified properties, and the trust is prohibited from acquiring more interests. In some cases, the trust has a defined termination date, but this can also be based on a certain threshold of production, or there may be no specified termination at all.The most common way mineral interests have been structured for public investment has been in the form of a trust.Distributions are paid on an established schedule (monthly is the most common), and these distributions are based on commodity prices and the level of production.  While the former depends on market forces, the latter tends to decline over time as the resources are drained from the specified properties. Thus, the stock prices of these trusts decline over time, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation.Because they are structured as a trust, these investment vehicles are required to distribute a substantial portion of their income. However, trusts can withhold a certain percentage of cash flows to pay trust administrative expenses or create a reserve for future distributions.  Because the interests in the specified properties are typically revenue interests, the trust is not required to pay for any expenses related to production, so expenses are relatively minimal.What is a Mineral Aggregator?The more popular investment vehicle for mineral interests recently has been the emerging sector of mineral aggregators. Aside from Dorchester Minerals, LP, which IPO’d back in 2003, the remaining five aggregators have gone public in the past five years, including Falcon Minerals and Brigham Minerals in the past twelve months.1 While aggregators also allow investors to gain exposure to the energy sector without investing directly in E&P companies or commodities, there are differences between aggregators and trusts, beginning with their structure.Dorchester, Viper Energy Partners, Blackstone Minerals, and Kimbell Royalty Partners are all structured as MLPs, while Falcon and Brigham are corporations.2 Eschewing the trust structure provides certain benefits to these entities. Aggregators are not restricted from acquiring more interests, and as their name implies, they seek to reinvest their earnings into the acquisition of new properties. The value of units in a public royalty trust tend to decline with production over time, but aggregators stem the tide of these losses with their reinvestment, and they do not have the statutory termination present in some trusts.They can also issue more common units, take on debt, and incur operating expenses in ways that royalty trusts cannot. While these make aggregators appear to be the better option, trusts by nature have beneficial tax treatment, and their yields tend to be higher and relatively more predictable given their distribution requirement, which mineral aggregators could decide to forego.A table summarizing the primary differences between a royalty trust and a mineral aggregator is included below:Market Data for Trusts and AggregatorsTo gain a better insight into how these factors play out in the public marketplace, we should analyze the data. The following tables gives some critical market data for valuation purposes: [caption id="attachment_27589" align="aligncenter" width="868"]Source: Capital IQ[/caption] While these trusts are predominantly focused on natural gas, many also have oil and NGL reserves. These natural gas trusts have the lowest market caps and relatively high dividend yields.  Compared to the crude oil trusts, these exhibit more diversity in product mix including notable amounts of NGLs. [caption id="attachment_27615" align="aligncenter" width="867"]Source: Capital IQ[/caption] [caption id="attachment_27609" align="aligncenter" width="860"]Source: Capital IQ[/caption] Compared to natural gas focused trusts, crude oil trusts tend to have relatively higher market caps with similar yield and pricing multiples, despite being based on a different commodity.  The levels of operating expenses are comparable as well. For this post, we have further delineated between perpetual and terminal crude oil trusts. The latter have a specified end date, while the former do not. However, both groups ultimately will receive distributions related to crude oil prices and declining production, regardless, whether there is a statutory termination or not. Going forward, we do not plan to group these separately.Mineral AggregatorsAs noted previously, mineral aggregators have been the apple of certain investors’ eyes lately.  They are not bound by distribution requirements, which allows aggregators to gobble up additional acreage.  This provides investors an element of growth in what has historically been a declining, yield-only return play. Despite no statutory requirements to distribute, the below aggregators have offered an attractive yield to investors. [caption id="attachment_27591" align="aligncenter" width="859"]Source: Capital IQ[/caption] When compared to the trusts, aggregators are significantly larger in terms of market cap and have notably more operating expenses and product diversity.  Also, they tend to trade at higher revenue multiples, with lower yields. While mineral aggregators may present an attractive option for investors, they are less functional as comparables for mineral interest owners. The lower yield, influenced by potential for return from future growth, and higher operating expenses render aggregators less comparable to traditional mineral interests.Other Valuation ConsiderationsNow that we have the data to back up the differences between trusts and aggregators, one must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest. While tempting, drawing valuation conclusions simply by selecting the appropriate commodity mix would be shortsighted. There are plenty of other considerations and judgments that need to be made such as:Timing quirks related to market pricing and dividendsIdiosyncratic issues with the operatorRegion/basin Dividends are a product of production and commodity pricing over the past year, whereas stock prices tend to be based on expected future commodity prices. WTI crude prices are expected to remain below $60/bbl for the rest of 2019, but dividends in the past year include those from back in late 2018, when some floated the possibility of crude oil returning to $100/bbl. Contrast this to a recent declaration that oil could conceivably drop to $30/bbl. With dividends paid out monthly, the numerator of the yield is impacted by stale prices that do not typically inform future expectations. These expectations, however, are a critical driver for the denominator, so bearish sentiment leads to higher yields. Higher yields inform current market sentiment about relative risk factors, however simply taking the prevailing dividend yield is not advisable.One must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest.Case in point(s): San Juan Basin Royalty Trust has not paid a dividend in the past year. That doesn’t mean there is no risk in their cash flows, it means there are no cash flows. On the opposite end of the spectrum, Whiting USA Trust II has a yield north of 77% as its quarterly dividends have nearly matched its prevailing market price. Again, this should not imply to a private mineral owner that their potential future revenue checks will carry this level of risk.Another important consideration for utilizing trusts as comparables is the operator of the subject interests. Take the three SandRidge trusts for example. Trust distributions are a function of both production and price, and SandRidge has struggled to maintain production given its various woes. Comparing the risk of a private mineral interest to one whose operator is hemorrhaging is not prudent.Finally, one must consider the region or basin. Geological factors distinguish the commodities produced in different plays and basins, and regional transportation dynamics also play a role.  As a result, investors may pay a premium to be in a basin such as the Permian. SandRidge Permian Trust bears many of the idiosyncratic issues as the SandRidge Mississippian Trusts, but it is in a more desirable location and therefore is expected to command a higher multiple. Again, production and price determine the distributions, and certain basins such as the Eagle Ford may provide the opportunity for premium prices while others like the Permian may be more attractive for other reasons.How These Factors Impact ValuationsTo value a currently producing royalty interest under the income approach, a valuation professional must determine some indication of projected future cash flows and discount these back to the present. Given the declining nature of the production, total return comes almost exclusively from the yield. Thus, we can use yields on public royalty trusts to discount the projected future cash flows of the subject interest back to the present. As noted above, judgment is required in determining the relative risk and return characteristics of the subject interest. As we noted in our last post, the SEC prices reserves based on a present value factor of 10%. While this is less applicable to PUDs and similarly more risky assets, private mineral interests that have been delivering consistent cash flows in the form of monthly royalty payments are more likely to be around this 10% discount rate, even if current yields indicate something higher.ConclusionWhen investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust.  The commodity mix, operator/sponsor, region, termination (or lack thereof), and other key aspects make each of these investment vehicles unique. Further analysis is required to verify these provide meaningful valuation indications.We have assisted many clients with various valuation and cash flow questions regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1      Actual IPO of entity holding Falcon Minerals occurred in 2017, but it discontinued its Special Purpose Acquisition Company (“SPAC”) in 2018.2     Viper and Kimbell have both elected to be taxed as C-corporations.

Brent crude prices began the quarter around $69 per barrel and peaked at nearly $75 in late-April before declining to just below $60 on June 12, 2019. Prices have since increased to $65, with WTI continuing to trail by about $8 per barrel. In this post, we will assess global supply and demand factors that have caused these price fluctuations.Global SupplyOriginally founded by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela in 1960, OPEC now stands at 14 members, after Qatar terminated its membership at the beginning of the year. OPEC is still a significant organization when assessing global supply, but it has undergone considerable changes. While OPEC only has 14 statutory members, an alliance known as OPEC+ has added 10 non-OPEC member countries headlined by Russia and including Mexico and Kazakhstan. This group agreed in December 2018 to a production decline with the goal of balancing global inventories and stabilizing the oil market (read: raising prices). With churn in its members and inclusion of allies in its production cuts, people may not know exactly who OPEC+ is, but the oil cartel’s mission remains clear (even if oil and cartel are not the O or C in the group’s amorphous acronym).OPEC+ has thus far been successful in reducing output, though for countries like Iran and Venezuela, decreased output hasn’t necessarily been intentional. In May, OPEC members produced 29.9 million barrels per day (b/d), the lowest for any month since July 2014. It remains to be seen if these production cuts set to expire this month will remain intact, and if so, for how long. Saudi Arabia’s energy minister Khalid al-Falih expressed absolute confidence that an agreement would be reached to extend the oil production cuts after “very constructive discussions” with Russian energy minister Alexander Novak. Falih also said,Our intent is to make sure that we continue to work together closely, not just bilaterally, but with all other members of the OPEC+ coalition – and that the good work we have done over the last two and a half years continues to the second half of 2019, maintaining supply constraints to bring balance to the global inventories of oil.The bilateral comment is telling. In April, the planned meeting was cancelled to reportedly have more time to analyze market data. However, the second delay, though only for a week, has shown heightened tensions, as decisions have increasingly been driven by Saudi Arabia and Russia, who combine for over 40% of OPEC+ oil production. Falih said all but one OPEC member nation has agreed to delay the group’s meeting until after the G20 summit, and the holdup figures to be Iran, who has been increasingly perturbed by its diminishing influence. Production cuts rely on all members to stick to their word, as each individual country would be economically incentivized to increase production to reap the benefits sown by those who withhold production.IranAlongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently.  In April, the U.S. reinstated its sanctions on importers of Iranian oil. The sanctions were initially implemented to ramp up “maximum pressure” on Iran as oil is a significant revenue source for the Iranian government. The U.S. is pressuring Iran to curtail its nuclear program and return to the negotiating table on a nuclear deal.Waivers were granted last November to allow countries time to find other sources of supply and three of these countries (Greece, Italy, and Taiwan) have done so as they no longer import any oil from Iran. China and India are the largest importers of Iranian oil whose waivers have been rescinded, which should ramp up pressure on Iran and could have spill-over effects on trade discussions as China expressed displeasure with the U.S.’s decision to reinstate sanctions.Alongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently.These sanctions are not the only concerns related to Iran. The recent crude price rebound following its 5-month low is due in part to Iran shooting down a U.S. drone, raising already heightened tensions. This comes after attacks in May on two tankers near the Strait of Hormuz, which the U.S. blames on Iran. The Strait of Hormuz, described by the EIA as the world’s most important oil choke point, separates UAE, Oman, and Iran and a significant amount of world oil supply passes through this relatively narrow shipping route.The White House has put out two statements in the past few days, seeking to set the record straight and with Saudi Arabia, UAE, and the UK jointly condemn these attacks. The situation remains fluid and volatile and continues to threaten the flow of oil, as President Trump began the week by announcing new sanctions on Iran.Rising U.S. ProductionProduction cuts from OPEC+ (intentional or not) have been able to raise prices since the lows seen at the end of 2018, and the U.S. has been one of the prime benefactors. The U.S. has been able to increase its global market share, increasing production to fill the void left by OPEC+ production. Additionally, any elevated prices caused by these production cuts have also increased top line revenues for American producers, a fact not lost on OPEC.According to the EIA’s latest Short Term Energy Outlook (“STEO”), U.S crude oil production increased 17% in 2018, peaking at an all-time rate of 10.96 million b/d.  This was capped by a December that saw 11.96 million b/d, the highest monthly level on record, despite crude prices sliding considerably in the fourth quarter. The EIA expects this growth to continue with production reaching 13.3 million b/d on average by 2020.Slowing Global DemandAccording to the STEO, the EIA is projecting lower crude prices for 2019 due to uncertainty about global oil demand growth. In late May, President Trump announced the potential for tariffs on Mexico, which would have particularly negative impacts on the energy industry as the U.S. exports more fuels to Mexico than any other country. Easing continental trade concerns, Mexico became the first country to ratify the USMCA (new NAFTA), though approval has yet to come from Canada or the U.S., and there is no timetable for its passage.Concerns about the U.S.-China trade relations picked up in the second quarter as increased tariffs have been threatened by both sides.Concerns about the U.S.-China trade relations have also picked up in the second quarter as increased tariffs have been threatened by both sides.  Expected industrial activity, as measured by the manufacturing Purchasing Managers’ Index (PMI) declined across several countries in May, and the U.S. PMI fell to its lowest level since 2009.  These contribute to concerns that future economic growth could be lower than expected, which would, in turn, curb oil demand. However, there was optimism on June 20, related in part to hopes that U.S.-Chinese relations would improve when President Trump meets with President Xi at the G20 Summit.Interest RatesOptimism on June 20 wasn’t restricted to trade with China as the Federal Reserve also met the prior day.  The Fed Funds rate has been increased 9 times since December 2015 to a target range of 2.25%-2.50%.  However, it has become increasingly clear that the next change is more likely to be up than down. For the first time in Jerome Powell’s tenure as Fed Chairman, a dissent was cast, which advocated for a rate cut. James Bullard, President of the Federal Reserve Bank of St. Louis, said cutting rates now “would provide insurance against further declines in expected inflation and a slowing economy subject to elevated downside risks. Even if a sharper-than-expected slowdown does not materialize, a rate cut would help promote a more rapid return of inflation and inflation expectations to target."In theory, interest rate hikes tend to be negative for risk assets such as equities and commodities such as energy. Conversely, a rate decrease should make holding these products more attractive and raise the price. More important, however, is the overall message it sends to the economy. If the Fed were to cut rates, even if it cited its inflation target as the reason (and not a global economic slowdown), this would be viewed by the market as a bearish signal, likely sending equities and crude oil prices downward.ConclusionWith the G20 Summit occurring June 28 and 29, we’ll close the quarter with a more informed outlook on global demand going forward. OPEC and OPEC+ meetings are expected to occur July 1 and 2, so we’ll have to wait until the beginning of the third quarter for a decision on increased, steady, or reduced production cuts on the supply side. Even with an announcement at the beginning of the quarter, it will take more time to determine how this production will be further impacted by individual country circumstances, particularly from Iran. In the meantime, the U.S. will likely continue its production to capitalize on the shortfall, even if global demand slows or is already slowing. While interest rate hikes or cuts will likely continue to play a role in market sentiment, it is unlikely we see a change on this front in the near-term.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have various impacts on prices. We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.

When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries) [caption id="attachment_26635" align="alignnone" width="790"]Source: Energy Education[/caption] Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value. Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As we discussed last week, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment.  Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns. While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income.  Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed.  Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise.  The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers.  A widely diversified customer base is typically worth more than a concentrated one.  Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied.  The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be.  When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry. In our next post, we plan to delve deeper into these special valuation considerations beyond the framework established in this post. Stay tuned…[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.

In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners. Many publicly traded trusts are restricted from acquiring other interests, so they have relatively fixed resources, and the value of these trusts comes from generally declining distributions. In many cases, the royalty comes from a related operator, though this is neither required nor characteristic of all trusts. There are also other MLPs such as Kimbell Royalty Partners, Viper Energy Partners, Dorchester Minerals, and Black Stone Minerals that are aggregators consistently gobbling up new acreage. In this post, we explore the subject characteristics of Permianville Royalty Trust, formerly known as Enduro Royalty Trust.Market ObservationsIt’s been a while since we’ve looked at this group, and Permianville Royalty Trust isn’t the only change. Hugoton Royalty Trust voluntarily delisted from the NYSE last August after not being able to sustain a sufficient stock price. Over the previous two years, the performance of the remaining 20 publicly traded royalty trusts and partnerships has varied widely.  The table below shows the performance and other key metrics of the 20 main oil and gas-focused entities that are publicly traded, as of March 28, 2019. [caption id="attachment_25737" align="alignnone" width="940"]Source: Capital IQ [/caption] Returns are pretty evenly split, with 9 positive and 11 negative. With oil prices rising 23% in the past two years and natural gas declining 8%, it’s not too difficult to pick out which trusts receive royalties from which commodity, though other factors such as timing and operator certainly play a role.For comparison, the chart below shows the two-year returns from Permianville Royalty Trust (PVL), crude oil, natural gas, the O&G150 Index, and a publicly traded E&P ETF called “SPDR S&P Oil & Gas Explore & Prod. (XOP)”. Interestingly, PVL has had little correlation with either crude (+25.9%) or natural gas (-37.0%) prices over the past two years, likely due to its exposure to both commodities and other notable activity specific to the Trust as discussed later.[caption id="attachment_25764" align="alignnone" width="940"]Source: Capital IQ [/caption] Permianville Royalty Trust Origination and SaleEnduro Royalty Trust was formed in May 2011 to acquire and hold a net profits interest (NPI) representing the right to receive 80% of the net proceeds from interests in certain oil and natural gas producing properties located in Texas, Louisiana, and New Mexico. These underlying properties were held by Enduro Resource Partners and are in both conventional and unconventional plays.  The initial IPO occurred in November 2011 issuing 13.2 million units at $22.  A second offering occurred in October 2013 issuing 11.2 million additional units at a reduced price of $13.85.  No further offerings or redemptions have occurred, leaving the number of Trust Units outstanding at 33 million, including the 8.6 million units originally retained by Enduro.Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas to reflect its holdings in the Permian and Haynesville Shale.On May 15, 2018, Enduro Resource Partners buckled under its debt load and filed for Chapter 11 bankruptcy.  This significantly impacted the royalty trust, similarly to how SandRidge’s issues have plagued its royalty trusts. Three days later, the Trust declared a dividend of $1.13 million, down 42.5% from the prior month, further exacerbating the decline.  The Trust’s share price declined 12.8% from May 10th to May 17th and fell to almost $3 per share a month after the announcement when it was trading closer to $4. On August 31, Enduro finalized a sale of the underlying properties and its outstanding Trust Units to COERT Holdings 1 LLC. This helped stabilize the stock price of the royalty trust as it increased from $3.4 on August 30th to $3.7 by September 6th. According to footnotes of an SEC filing, COERT Holdings paid an aggregate gross consideration of $35.75 million for the 8.6 million Trust Units held by Enduro.  This implies a unit price of about $4.16, significantly higher than the price seen around this time.In connection with the sale, COERT assumed all of Enduro’s obligations (became the “Sponsor” of the Trust) with minimal disruption to unitholders anticipated. Notably, the portfolio consisted primarily of non-operated interests, easing any transition concerns. Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas, changing its name to Permianville Royalty Trust to reflect its holdings in the Permian and Haynesville Shale. It should be noted, however, that not all of its holdings in East Texas are in the Haynesville.Permian + Haynesville = PermianvilleUnderlying PropertiesThe Permian has dominated shale production in the U.S. over the past year, but Haynesville Shale has made a push of its own recently. It surpassed the Bakken with 58 rigs in the first week of March, which it has only done for a brief period at the beginning of 2018 and before then in 2011 when it also had more rigs than Appalachia and the Eagle Ford. According to the EIA March Drilling Productivity Report, Haynesville only trailed Appalachia in new-well gas production per rig while legacy gas production has declined slower than both Appalachia and the nearby Eagle Ford. Despite these gains, the Permian still dominates in terms of production and the majority of Permianville Royalty Trust’s acreage is in the Permian basin with 88% of net acreage and 92% of net wells.[caption id="attachment_25756" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption] As seen in the chart below, the majority of the Trust’s proved reserves are developed, oil reserves at 59%.  Natural gas makes up approximately 38% of reserves, split between producing and undeveloped. This makes sense as the Permian is the main focus of the Trust, with Haynesville adding a bit of upside in terms of reserves with potential that have yet to begin producing. [caption id="attachment_25757" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption] Operators and CustomersAs noted earlier, Permianville Royalty Trust is operated predominantly by operators other than COERT.  Only 17 of 3,748 gross wells (0.5%) are operated by the Sponsor, and these wells are in the East Texas/North Louisiana region. Other operators include Aethon Energy Operating, BHP Billiton, EXCO Resources, and Indigo Resources. The primary operators in the Permian Basin are Apache Corporation, XTO Energy, and Occidental Petroleum.  Most drilling activity for the underlying properties in 2018 was focused on the Permian Basin with six gross (0.5 net) wells drilled in 2018. In 2017, roles were reversed as six gross (0.5 net) wells were drilled in the Haynesville Shale. While capex budgets are determined by each individual operator and subject to change (as we saw many operators do in 2018) the Sponsor anticipates capex for 2019 to range between $5 million to $7 million prior to consideration of the 80% NPI.The top purchasers of the oil and gas produced from the underlying properties are displayed in the chart below. The realized prices are also included. Notably, the realized price on natural gas increased in 2018 despite declines on the NYMEX, likely because most of the gas harvested is near the Henry Hub.[caption id="attachment_25758" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K*Applicable NPI Period per 10-K[/caption] Termination of the TrustA traditional royalty interest typically continues into perpetuity. In contrast, many public royalty trusts have a set termination based on a specific date and/or production level. Permianville Royalty Trust differentiates itself as it is not subject to any pre-set termination provision such as time or production.  The Trust will dissolve upon the earliest of the following:The Trust sells the NPI (subject to approval from at least 75% of unitholders);The annual cash proceeds received by the Trust attributable to the NPI are less than $2 million for two consecutive years;75% of unitholders vote in favor of dissolution; orThe Trust is judicially dissolved. Upon dissolution, the trustee would then sell all of the Trust’s assets and distribute the net proceeds of the sale to the trust unitholders. Net profits allocable to NPI have been $15.2 million, $7.5 million, and $9.3 million in the past three years, mitigating concern the Trust would be dissolved in the near-term.Disposal of Interests Related to Permianville Royalty TrustNPI received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets; however, unitholders will be compensated if a sale occurs.  Without a vote of approval, the Trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders.  The sale also cannot exceed a fair market value of $500,000, and both limits are common features of royalty trusts. COERT sold a couple of producing wells and corresponding acreage in Glasscock County for approximately $62 thousand in January 2019.With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects.To make a larger sale, approval originally required consent from 75% of unitholders. However, at a special meeting in August 2017, unitholders approved amendments to the Trust Agreement decreasing this figure to a simple 50% majority. The next month, the Trust under Enduro’s stewardship divested $49.1 million worth of its underlying properties. Net of transaction expenses, the 80% NPI, and an indemnity holdback, the Trust distributed nearly $38 million to unitholders, a special dividend amounting to about $1.15 per share. By comparison, the Trust has only distributed about 90 cents per share in regular monthly dividends over the past three years. As expected, shares of the Trust spiked upon announcement of the special dividend, then decreased by approximately the amount of the dividend once paid a month later.Divestitures are much more common in the oil and gas industry than the general market as companies seek to develop expertise in core regions. With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects. The need to service this debt sometimes causes E&P companies to divest certain holdings. This is why industry participants frequently refer to transactions as A&D (acquisitions and divestitures) as opposed to M&A (mergers and acquisitions) in other industries.Such disposals, like the divestiture made by Permianville Royalty Trust, can have either positive or negative impacts on unit/shareholders. Ultimately, it depends on the sale price achieved. For royalty trusts, large divestitures lead to special dividends that represent an expedited yield. This could be a positive as such investments are typically seeking a return of their capital with declining distributions. According to the principles of time value of money, it is better to receive cash sooner rather than later. However, such divestitures could lead to different tax treatment and alter the expected return profile for investors. Also, if prices or production turn out to be higher than expected, the upfront sale can have a negative impact in the long-run. This is particularly interesting for Permianville Royalty Trust as it does not have a defined termination date.ConclusionThe performance of Permianville Royalty Trust has varied over the past two years, as it divested assets, changed its name and sponsor, and experienced commodity price volatility. Those who initially sold their units after Enduro filed for bankruptcy may wish they had held on longer. This is certainly true for people who couldn’t wait for oil prices to rebound following the crash in 2014 and likely anyone who sold prior to the announcement of the special dividend in 2017. After the Q4 dip in prices, the Trust also announced its largest monthly dividend since July 2014 concurrent with its 2018 10-K filing, boosting share price further.[caption id="attachment_25763" align="alignnone" width="940"]Source: Capital IQ [/caption] When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust.  The source of income, region, operator, sponsor, termination (or lack thereof), and other key aspects make each trust unique. We have assisted many clients with various valuation and cash flow questions regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Nearly a quarter of the way through 2019, prices have rebounded somewhat after a tumultuous end to 2018.  First quarter energy prices again moved in opposite directions, with crude prices increasing steadily over the period while natural gas prices decreased from $2.94 to $2.80 per Mcf by mid-March despite peaking at over $3.50 in mid-January.Location, Location, LocationBorrowing the mantra of many real estate agents, sometimes it’s all about location, location, location.  This is quite clear for oil and gas plays, particularly when looking at the acreage multiples paid across various regions. Eagle Ford Shale has quietly delivered solid results, overshadowed by some of the other shale plays, particularly the Permian to the west.  The Eagle Ford’s location provides a distinct advantage, however, as it is closer to higher Brent-related pricing seen on the Gulf Coast. Its higher cut of oil also opens it up to Louisiana Light Sweet pricing. Even though the attention on the Permian has increased both acreage multiples and congestion due to transportation issues, it has been less of a concern in the Eagle Ford because the product has a shorter distance to travel to get to market.While proximity to better pricing is clearly a boon, location within the region also plays a large role.While proximity to better pricing is clearly a boon, location within the region also plays a large role. The Eagle Ford has areas where the cost of supply is as low as $20 to $30 per barrel according to Greg Leveille, Chief Technology Officer of ConocoPhillips. EOG Resources, the largest operator in the region, has noted similar supply costs as well. According to Thomas Tunstall, senior researcher with UTSA’s Institute of Economic Development, “EOG has some of the choicest leases in the Eagle Ford. They have indicated publicly that they can make money at $30 per barrel.” This has a considerable impact particularly with WTI prices currently trading around double that figure.According to Bloomberg, breakeven prices tell a similar story. While the West Eagle Ford has the highest breakeven of these regions, the East Eagle Ford has the lowest. Though it can be difficult to isolate reasons for these differences, Bloomberg’s breakeven prices in the table below do seem to corroborate the assertion that location plays a role as the eastern portion of the Eagle Ford is closest to the Gulf Coast with the Brent and LLS pricing.Free Cash Flow vs Potential — Safe vs SexyAs we noted last week, operators in the Eagle Ford have enjoyed the reliable production inherent in a later life-stage play. Along with the pricing benefits noted above, companies that have operated in the region for a while have been able to benefit from experience.  Todd Abbott, Marathon Oil’s VP of Resource Plays South, attributed the company’s success in the region to drilling innovation and efficiency and repeatability of a stable drilling program.  He further noted, “We are completing wells in a quarter of the time it took us to complete them in 2012.” This notion was furthered by ConocoPhillips’ CTO Leveille who touted innovations in well-spacing and stacking have allowed the company to achieve a 20% field-level recovery factor in the Eagle Ford Shale. Technical innovations and experience have led to free cash flow for operators, which is something investors have been seeking. It also allows for diligence in capital spending, where investors have also begun to prioritize capital efficiency over capital expenditure. In fact, according to Marathon’s Abbott, the Eagle Ford has been able to effectively subsidize its efforts in regions such as the Permian and Oklahoma Stack as it is generating the free cash flow that the others are consuming. Still, the Eagle Ford lacks some of the luster of other plays.Valuation ImplicationsTo further understand the current production profile of the Eagle Ford and oil and gas plays in general, we can compare them to a typical company. In the early stages, companies retain earnings to fund growth opportunities as the return on investment can be quite high. As the company matures, however, there are fewer high return investments to be made, and companies tend to pay more dividends. Returns shift from capital appreciation from retained earnings to a yield in the form of dividends paid as a reward for years of investment. The Eagle Ford is in the stage of paying dividends.As has been the case for some time now, operators in the Permian continue to lead the other regions in terms of EV/production multiples, also known as price per flowing barrel.  The Bakken was about on par with the Permian at the end of 2018, but it slid back towards the Eagle Ford, which edged up over the past three months.  Multiples continue to trail levels seen in the past as enterprise values have been somewhat lower and production figures have increased.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America decreased 4.2% in the last three months, but increased 3.6% over the last twelve months. Eagle Ford Shale had the highest annual increase at 15.5%, but its 82 rigs only represent 8.0% of total rigs in North America.  Despite a 4.5% decline in the past three months, the Permian Basin continues to lead the way with 464 rigs, representing about 45% of the total.  By comparison, the Eagle Ford has the second most rigs, just outpacing Appalachia at 79 and the Bakken with 56.Despite the increase in rig counts, production increases over the past year for both oil (14.4%) and gas (8.3%) have trailed production gains seen in other regions.  This is likely due to the older nature of the play, and its stage in the production cycle.  The lack of production growth does not mean there is low production, however.  It continues to provide solid production, with crude oil production on par with the Bakken, and significantly above Appalachia, known for its natural gas.  The Eagle Ford also leads the Bakken in terms of natural gas production. Much of the attention, particularly in Texas, has been on crude as opposed to natural gas.  Despite this, the graph above shows natural gas production in the Permian has increased significantly in the past year.  As noted earlier, the Eagle Ford’s location, specifically its proximity to the Henry Hub in Louisiana, may be a reason why the chasm between the amounts of natural gas produced in the two regions hasn’t increased further than it has. Much like crude, operators focused on natural gas in the Eagle Ford have benefitted from higher pricing as well as lower costs. According to Michael J. Wieland, President and CEO of Laredo Energy VI LP, the economics of dry gas in the Eagle Ford are particularly strong. Wieland further estimated finding and development costs at 50 cents per thousand cubic feet (Mcf) and netbacks of about $2/Mcf.  SilverBow Resources’ EVP and CFO, Gleeson Van Riet, said the company has drilled 20 of the top 50 Eagle Ford gas wells and that the play is the best place to be in the U.S. for natural gas because it has best prices, good infrastructure and is located in the demand growth area. SilverBow (formerly Swift Energy) is the Eagle Ford’s only public pure-play in dry gas. Whether an operator focuses on crude oil, natural gas, or both, neither seems to be in short supply in the region. End of an Era?While there is plenty of current production in addition to cash flow, there are concerns about the longevity of the region. Even regional giant EOG is looking to diversify. On a recent earnings call, EVP of Exploration & Production Ezra Yacob noted expanding exploration in those areas will “help increase the quality of our inventory” and “should hopefully shallow the decline that these unconventional plays are kind of known for.” The company still plans to drill about the same number of wells in the region in 2019, after posting a 9% crude oil production increase. The Eagle Ford represented 43% of EOG’s crude production last year, so diversifying to other regions doesn’t necessarily indicate a bearish view. Instead, it seems to be in line with the strategy alluded by Marathon, using the cash flow generated in the Eagle Ford to pay for growth in other plays.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas. Director at BMO Capital Markets Max van Adrichem called the Eagle Ford a good alternative to “some of the more mature basins which may not have enough running room to get you through 5 to 10 years.”  Martin Thalken, Chairman and CEO of pure-play Eagle Ford operator Protégé Energy III, supports this line of thinking. He commented the Eagle Ford “is still in the early innings” on applications like primary EOR and refracturing. John Thaeler, CEO of Vitruvian Exploration IV also employed a baseball analogy, saying “the dry gas Eagle Ford is just in the second inning.” Marathon’s Abbott agrees, “We believe there is a lot of running room left in the Eagle Ford for Marathon and the rest of the industry.”ConclusionCrude prices have rebounded since the turn of the year, while natural gas prices have remained steady. Pricing will always be dynamic in a global commodity environment, but the economics of certain plays tend to be less fluid.  While it may not offer the potential of the Permian, the Eagle Ford is poised to leverage its experience and location to deliver solid returns.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world.  Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Commodity prices exhibited significant volatility to end 2018 with steep declines in crude prices and a spike in natural gas prices that subsequently fell back.  The general market also declined over the period, making it difficult to parse reasons for various stock price gyrations.  While lower prices aren’t ideal for industry operators, earnings calls remind wary investors that there’s more to price than what trades on the NYMEX. Executives this quarter also note a shift in focus when it comes to capital outlays.We take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1:  Hedging Protects Operators from Lower Crude Prices Our 2019 crude oil hedge positions remain unchanged. We have 95,000 barrels of oil per day hedged for calendar 2019 with $60 WTI put option contracts. We expect option premium amortization will be approximately $29 million per quarter in 2019. –John Rielly, CFO, Hess CorporationIt is notable that we remain the only publicly traded U.S. producer that is 100% hedged on expected natural gas production in 2019. –Glen Warren, President and CFO, Antero Resources CorporationIn order for operators to mitigate risk and volatility in commodities such as crude oil and natural gas, many companies will engage in hedging, mostly by use of derivative instruments. This ability to effectively pay a fixed price over future periods of time, commonly in the form of commodity futures and various option contracts, allows for more certainty and stability in cash flows particularly when prices exhibit volatility. This is particularly important for an industry that requires significant capital outlays and long term budgeting plans. While hedging is certainly beneficial when markets behave as they did in Q4, it is important to realize these contracts come at a cost as noted in the Hess quotation above. In response to analyst questions, Hess Corp’s CEO noted future hedging would be of a similar structure where they “protect the downside but we don’t cap the upside.”Hedging protects E&P companies from adverse price realization, effectively propping up operations when commodity prices fall.  These instruments tend to smooth results, so revenue does not drop too severely in bad times, though its costs do lower profits in times of rising prices.  When valuing E&P companies, the increased cost would be a calculated reduction in value; however, hedging lowers volatility and risk. If companies sought to save this cost and expose themselves to commodity risk, it could be subject to a higher discount rate to account for these risks. Ultimately, hedging is a form of insurance and is a cost of doing business.Theme 2:  Local Pricing and Transportation Issues Also Obscure Prices Achieved by Operators2018 was a volatile year for oil prices, especially in the Permian. As you can see on Slide 4, we successfully navigated a challenging midstream takeaway situation throughout the year and delivered a realized oil price that comfortably outpaced both, our peers and local Midland prices. Even more importantly, our proactive marketing strategy delivered ample flow assurance without burdening our long-term pricing structure. So we would expect to stay near the top of the class on this measure in coming years. –Matt Gallagher, President and CEO, Parsley Energy, Inc. [caption id="attachment_25161" align="aligncenter" width="459"]Source: Parsley Energy Earnings Presentation, Slide 4[/caption] Our strategy is to have multiple export markets here to provide us flexibility to move our oil into the highest value market. So, we can get about 70% of our oil to the coast to get the Brent influenced pricing. –John Rielly, CFO, Hess CorporationThe ability to sell this oil at Brent-related pricing has had a very positive impact on both margins and returns in 2018. For instance during the fourth quarter, we moved about 90% of our oil to the Gulf Coast which had the effect of increasing our oil margins by over $9 per barrel. –Rich Dealy, Executive Vice President & CFO, Pioneer Natural Resources Company [caption id="attachment_25167" align="aligncenter" width="527"]Source: Bloomberg[/caption] A recurring theme throughout 2018 was the pricing differentials between localized prices and those seen on different exchanges such as the standardized Cushing, Oklahoma. The Brent-WTI spread was also pronounced throughout the year, with an average spread of $6.79 per barrel, peaking at $11.37 in June. Capacity constraints from a lack of infrastructure in place to bring the product to market played a role in this, and operators in all regions dealt with localized pricing differentials. As we see from these quotes, many operators are seeking markets where they can achieve higher pricing, particularly those related to Brent in the Gulf Coast.Higher prices received for a given level of production increases profit for E&P companies, but transporting the product to these markets incurs increased costs too. Ultimately, companies must balance the increased revenue with the incrementally increased costs to make sure returns are realized from this strategy.Theme 3:  Lower Prices Reign in CapEx BudgetsLast month we discussed various capital budgets through three different pricing scenarios, but we've decided to limit our full capital spend in 2019 to $4.5 billion. This represents a $500 million or a full 10% reduction from 2018. By maximizing efficiencies, we are reducing spending to adjust to a lower oil price environment. –Vicki Hollub, President and CEO, Occidental Petroleum CorporationIf we get extended in an extended low-price environment and really would have to go really more into 2020, the tail-end of 2019 into 2020, in that  case an extended low-price environment we have the flexibility as we mentioned to reduce our annual CapEx by as much as $1 billion and that’s principally by reducing rigs in the Bakken. –John Hess, CEO, Hess CorporationIn an effort to align spending with cash flow projections both Appalachia and Permian producers are reducing 2019 capital budgets, which results in lower supply growth in 2019 with an even more meaningful supply impact in 2020. –Glen Warren, President and CFO, Antero Resources CorporationAntero will remain flexible depending on the commodity price outlook. We will remain disciplined, spending within cash flow in a low case but have the ability to prudently grow production to maximize free cash flow if commodity prices improve ultimately delivering an appropriate mix of return of capital to shareholders and further deleveraging. –Paul Rady, Chairman & CEO, Antero Resources CorporationMany CapEx budgets for 2019 and beyond were revised downward after the steep drop in oil price as it makes less sense for operators to ramp up production under these conditions. As is noted above, CapEx budgets will remain flexible as an increase in prices would induce operators to produce more in the short-term.Higher CapEx spending in the near term increases revenue for E&P companies, though this will ultimately decrease overall return if the operator does not scale back production until prices rise again.Theme 4: Market Not Paying for Growth Without ReturnCapital discipline has been the buzzword in the E&P industry throughout most of 2018, and certainly as we enter 2019. At Marathon, we have a very clear working definition of capital discipline […] It means prioritizing sustainable free cash flow generation at conservative prices over growth for growth sake. We've been very clear that production growth is simply an outcome of our disciplined capital allocation process, and given our commitment to returns and cash flow, we emphasize high-value oil growth to drive both high margins and capital efficiency. And with sustainable free cash flow, capital discipline for us is also a commitment to return capital back to shareholders, through both our peer competitive dividend and thoughtful share repurchases. –Lee Tillman, Chairman, President, and CEO, Marathon Oil CorporationThe steps we took in 2018 will be really important when it comes to 2019 in the sense that we in our 2019 plan can point to a significant CapEx decrease about 11% compared to 2018, while at the same time delivering a strong 15% increase in production. So, we're very excited about what 2019 holds when we can show that kind of capital efficiency gains. –Tim Dove, President & CEO, Pioneer Natural ResourcesWell, I think, first of all, we are slowing down growth, if you look at this year compared to the prior two years, we've been well into the 20s in terms of growth percentages. We have moved this down. We have a range now which centers on 15%. Obviously, we can ratchet within that range at a moment's notice. It's based on how much activity we want to execute on. But fundamentally, we've taken significant steps to increase basically return of capital to shareholders and we wouldn't have a $2 billion share repurchase plan if that wasn't the case. But I think we have to go further. –Tim Dove, President & CEO, Pioneer Natural ResourcesParsley expects to see an 8% to 10% plus year-over-year improvement on capital efficiency during 2019. We expect both productivity gains and CapEx savings to drive this improvement as detailed down the right hand side of the slide. –Matt Gallagher, President and CEO, Parsley Energy, Inc. [caption id="attachment_25160" align="aligncenter" width="519"]Source: Parsley Energy Earnings Presentation[/caption] As a consequence to reductions in capital budgets, companies are emphasizing capital efficiency over capital expenditures. The market has indicated that a perpetual cycle of growth not sharing the returns with investors is becoming less appealing. Doug Leggate, a Merrill Lynch analyst and frequent participant on industry earnings call Q&A sessions, posed this question directly to Pioneer, specifically noting the share price had not increased since March 2016 despite production doubling in that time frame. The CEO’s response is our third quotation above. Companies will need to strike a balance between funding their growth operations, paying down debt, and returning capital to investors in the form of dividends and share repurchases.Capital efficiency, that does not negatively impact long-term growth prospects, would increase the value of E&P companies as it focuses on increasing returns. In the typical Gordon Growth model for determining intrinsic value of a stock, it gives investors a return in the form of dividends as opposed to capital appreciation, which is only rewarded if the market is willing to pay for it.

As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry.  This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own. We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1] Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.”  As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres.  That is: 640 acres per section times ¼ times ½. The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow: “To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.” This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at: 80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals.  This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved.  As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country.  Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value.  For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO

As the calendar turns to 2019, we turn our attention to the Appalachia region, and not by coincidence. Cooler temperatures in the winter months tend to lead to increased natural gas prices and consumption, and the Appalachia region is the largest natural gas producer in the country.  Fourth quarter energy prices moved in opposite directions—crude prices declined steadily over the period and natural gas prices increased from about $3.0 to $3.5 per Mcf, peaking at over $4.8 in mid-November.November Price SpikeIn its December edition of the Short-Term Energy Outlook, or STEO, the EIA reported the price of Henry Hub averaged $4.15/MMBtu in November, up 87 cents, or 27% from October. It attributed this increase to colder temperatures and lower inventory levels.  The EIA estimated that inventory in the U.S. stood at 3.0 trillion cubic feet at the end of November, which was 19% lower than the five-year average.Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree.Declining nearly 26% since its peak six weeks prior, the run-up in natural gas prices appears to have only been temporary. As we discussed with crude oil in our Q2 newsletter, higher inventory helps to smooth price volatility in the energy market. During this part of the year, natural gas inventories are drawn down as people fire up their heating units, but this year the initial draw down of inventories hamstrung as U.S. natural gas inventories began the season at a 15-year low. Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree. Milder weather forecasts and energy substitutes (coal) have reigned in prices as well.As we alluded to recently, the price spike was also due in part to short covering by hedge funds in response to the rapid decline in crude prices. Worried investors diverted funds from oil to gas to compensate for accumulating losses in oil. Given the smaller nature of the gas market compared to oil, there was an uptick in activity and prices. Quickly rising prices led to an overbought market that subsequently corrected and has been trending downward with trading volume throughout the end of the year.Appalachian Ethane Storage HubAt the beginning of December, the U.S. Department of Energy published a report to Congress on the feasibility of establishing an ethane storage and distribution hub in the United States, specifically, the Appalachia region. The report noted that significant production growth is expected to occur in the Permian and Appalachia, though the latter trails the former in terms of current infrastructure (95% of ethane storage in the U.S. is located near the Gulf Coast). Storage hubs balance seasonal supply and demand variations, and are crucial to smooth volatility, as evidenced by the November activity. The report notes that a distribution hub near the Marcellus and Utica plays would help allay geographic concentration risk along the Gulf Coast that is susceptible to severe weather events (e.g. Hurricanes Harvey and Irma). While such a hub would provide a competitive advantage, the report crucially notes it would not be in conflict with further expansion of infrastructure in the Gulf Coast.U.S. Secretary of Energy Rick Perry, who signed the report, said, “There is an incredible opportunity to establish an ethane storage and distribution hub in the Appalachian region and build a robust petrochemical industry in Appalachia.” While the report focused on the economic benefits of a hub, detractors note the lack of consideration of environmental costs. It remains to be seen how this will impact production and pricing in the region, but it would undoubtedly be a boon for the region and the industry.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America increased 2.9% in the last three months and 16.6% over the last twelve months. The Permian Basin led the way and currently has just fewer than 500 rigs, representing about 46% of total rigs in the U.S. By comparison, the Appalachia region has had below 80 rigs since July 2015 though it has remained relatively consistent, above 70 since last May.Though production has spiked, Appalachia significantly lags the other regions in terms of total production.Oil production in the Marcellus and Utica plays has increased by 45.1% in the past year, growth even higher than the Permian.  Though production has spiked, particularly in the second half of the year (up 34.8% since June alone), it’s important to recognize the magnitude: Appalachia significantly lags the other regions in terms of total production.Natural gas is the major focus of the region, where production has increased 15.5% in the past year, trailing both the Permian (34.1%) and the Bakken (25.1%).  Again, size plays a role in these growth figures as Appalachia has about 2.5x the production than the next largest play, the Permian. A deeper dive into the DUCs tells a slightly different story, however, with the inventory of drilled but uncompleted wells declining 17% in the region over the past 12 months. This could temper the rate of growth for production for the region in 2019 if drilling in the regions doesn’t increase.Valuation ImplicationsAppalachia has consistently lagged the other regions in terms of EV/production multiples, also known as price per flowing barrel.  The Permian took center stage in 2017 but has retreated back to the rest of the pack.  The lower multiple seen in Appalachia is largely due to declines in enterprise values, though increasing production has played a role as well.Despite the recent increase in price, the EIA expects increased production in 2019 will cause the average price of natural gas to drop 6 cents, compared to 2018, to $3.11. This could explain why key players in the region are seeing lower stock prices.Range Resources is the largest natural gas producer in the Marcellus, but it has not seen a positive impact from higher prices over the past few months. The company’s share price has dropped further than the overall market, but this cannot solely be attributed to swings in natural gas prices. While Range’s share price has dropped along with the recent slide, it did not get the same treatment when the market spiked in mid-November. Since its long-term debt obligations do not begin to mature until 2021, the drop in share price has had a significant impact on its enterprise value. Range is uniquely positioned with capacity on the Mariner East 1 pipeline that will allow it to tap into the rising global demand for NGLs, so there is potentially an upside to its current price.ConclusionNatural gas prices have followed a curious path in the past three months with index prices spiking at the Henry Hub, but gas being flared in record proportions and even given away at a loss in the Permian. While pricing will remain dynamic, there are certainly positives for natural gas producers heading into 2019 with the potential for an ethane storage hub in the Appalachia region and a ramp-up in production of NGLs to satisfy the global market.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Improvements in technology have driven the shale revolution. Among these improvements are both cost cutting by oilfield service providers and longer laterals from E&P companies. While capacity constraints from a lack of infrastructure has led to pricing differentials (particularly in the Permian Basin), a lack of inventory in the global oil market is expected to support higher prices, while also increasing price volatility.As we plan to do every quarter, we take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Regardless of Region, Longer Laterals are Driving Efficiencies for E&P Companies[W]e continue to capture efficiencies through longer laterals. Last year, our program averaged 8,000 feet, but our portfolio high-grading efforts and asset swaps are enabling us to push beyond that, especially in New Mexico. Our average lateral length for the entire program will increase 20% next year to 9,700 feet. – Jack F. Harper, President and CFO, Concho Resources, Inc.We expect to continue to improve returns through the use of longer laterals and optimizing completion techniques. – Taylor L. Reid, Director, President, and COO, Oasis Petroleum, Inc.[T]here's quite a bit of room for 15,000 foot and even longer laterals in the Eagle Ford, particularly in the Western area. […] On the Permian, it's really driven by the existing well in the lease geometry. So there's areas where there's quite a few 15,000 foot wells. – Herbert Vogel, EVP – Operations, SM EnergyThe well mix in the Eagle Ford during the third quarter included a higher proportion of western acreage wells. While the pay is thinner in the west, there's less faulting, which allows for longer laterals. The longer laterals you can drill, the better the efficiencies to be gained during drilling and completions. – Ezra Y. Yacob, EVP of Exploration and Production, EOG Resources, Inc.When you break down the value of drilling long laterals, there are three areas to consider: development efficiency; well performance; and capital efficiency. [… Development efficiency] is our ability to maximize access to the reservoir with a single wellbore, allowing us to develop more acreage and resource from a much smaller footprint. […] It’s still early in the game when it comes to evaluating well performance for long laterals […] but none of our reviews have indicated any adverse impact of lateral length to well performance. […] Longer laterals can significantly reduce and even eliminate a number of costs in areas such as well pad and road construction, top-hole drilling, drilling and completion mobilizations, surface facilities and reduce cycle times. […] We are now at the point where the time to drill an additional 5,000 to 10,000 feet of lateral length may only be a couple of days requiring minimal incremental capital to being spent. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Longer laterals allow companies a host of advantages in terms of cost, while not necessarily negatively impacting performance. While longer laterals have been used in the industry for some time now, industry players have been more vocal about the possibilities created by drilling longer laterals. Lateral length has consistently increased over the years. For example, the average lateral length per well in West Virginia was 2,500 feet in 2007, compared to more than 7,000 feet in 2016. Although they are not the common place, many operators have reported laterals in the 12,000 to 13,000 feet range.Longer laterals lower costs for E&P companies which increases firms’ values with more revenue reaching the bottom line. Of course, there are limitations. Longer laterals generally require the consolidation of acreage ownership.Theme 2:  Oilfield Services Costs are Expected to Remain SteadyNew technology is increasing drilling speeds, drilling more consistent targets and lowering cost, all at the same time. Combined with cost reductions from local sand, water recycling and infrastructure projects, we are well on our way to achieving our stretch goal of reducing average cost 5% by year-end 2018. […] As we near the end of 2018, industry activity is slowing. Consequently, the service sector is experiencing a period of softness in the market. To take advantage of market conditions, we elected to secure some of our existing service providers through the fourth quarter for next year's program. This will capture favorable prices and sustain the operational continuity of these high-performing service providers into 2019. –  Lloyd W. Helms, Jr., COO, EOG Resources, Inc.My perspective long term on service costs is that what [oilfield service] companies really needed was utilization and now we're seeing that across the industry. A lot of them are pretty much fully utilized. And we still see a lot of expansion within our industry today. That's what's going on when you look broadly. So, these service companies are getting healthier all the time. And so, instead of just forcing prices up, continually getting more efficient and with more utilization, we think it could stay in about the same plane that it's in today. – Harold G. Hamm, CEO, Continental Resources, Inc.[W]ith respect to service costs, what we're seeing at least at this point is not a lot of move overall in the service costs. There are pockets of small things that we've seen bump up. We're optimistic on the pressure pumping side that it's going to be flat to down. And so we're not anticipating a big move in service costs for 2019, but we'll continue to monitor that. – Thomas B. Nusz, Director and CEO, Oasis Petroleum, Inc.In regions where drilling has ballooned, service providers are fully utilized. New players are entering these markets to deal with the expansion, which has helped keep prices steady.  In regions where there is less activity, some players are looking to lock in longer-term contracts to take advantage of lower costs. Regional market dynamics are different, though the impact on oilfield service costs appears to be the same.Increased activity means more revenue for E&P companies and oilfield service providers.  However, if oilfield service providers are able to command a higher price, E&P companies, valuations will suffer.   However, the majority of industry players believe that oilfield servicers will not continue to raise prices next year.Theme 3:  Infrastructure Issues PersistCosts have started to stabilize as the industry awaits new long haul pipe capacity before increasing activity […] the drilled but uncompleted backlog has reached new highs and will likely be a catalyst for activity once the new pipeline projects are completed. The Midland discount to Cushing's WTI has narrowed as capacity may come online sooner than previously expected. The futures curve indicates that Midland barrels will be priced at a premium WTI in 2020 and beyond. – Timothy A. Leach, Chairman & CEO, Concho Resources, Inc.Range has also seen significant, improved in-basin pricing compared to last year as the Appalachian gas market is benefiting from new pipeline capacity additions in both northeast and southwest Pennsylvania […] Over the next couple of years, we expect basis to remain strong in southwest Pennsylvania as additional pipelines are placed into service that will keep that portion of the basin free-flowing in the other markets. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Although we expect to see oil differentials to be wider for the fourth quarter, we retain our existing annual guidance, although likely in the upper half of the guidance range. The productivity of the Bakken is driving a significant expansion of basin takeaway. We expect to see the expansion of existing pipeline capacity as well as new pipelines entering the basin. Some of this capacity will come online in the next few months with a strong ramp-up through 2019 and entering 2020. On the gas side, we expect fourth quarter gas differentials to remain strong and reiterate our annual guidance. Looking forward to 2019, we expect a significant expansion of gas processing capacity in the Bakken, expanding as much as 50%. – John D. Hart, SVP, CFO, and Treasurer Continental Resources, Inc.If you look at the DAPL [Dakota Access Pipeline] and size that line until you know that you've got expansion capabilities there that it's going to be almost 40% more capacity that's going to come on with that eventually. That was from their initial projections to where that's going to go. So, that's a good bit of capacity right there that they'll be adding. And the next is new construction. Obviously […] there's a lot more oil to come out of the Bakken. And so, these new pipeline projects are going to pay off beautifully as time goes on. So, there's going to be a lot of brownfield, greenfield pipe to be added. – Harold G. Hamm, CEO, Continental Resources, Inc.As we’ve discussed, differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter due in large part to capacity constraints from a lack of infrastructure in place to bring the product to market. As we see from these quotes, infrastructure issues aren’t confined solely to the Permian as many operators are dealing with in basin pricing differentials. Infrastructure issues are curbing the gains that are typically associated with rising prices and production. Theme 4:  Less Inventory in the Global Market Leads to Higher Prices and More VolatilityLooking at the macro environment, with the oil markets in a more balanced position, OECD commercial stocks have declined to below the 5 year rolling average. U.S. crude and product stocks, which account for around 40% of total OECD inventory, have reduced significantly over the last year to the middle of the range. With lower stock levels, the oil price remains volatile to any uncertainties, particularly around supply and geopolitics. Recent factors include the impact of U.S. sanctions on Iranian exports, supply disruption from Venezuela, together with production uncertainty from Libya and levels of spare capacity within OPEC. In summary, the oil price outlook has strengthened. We expect the oil market to remain volatile in the near term, characterized by lower stock levels and ongoing geopolitical factors. We expect current supply concerns to ease and continued robust demand growth to be matched by growth in the U.S. tight oil production and additional supply from non-OPEC countries. – Brian Gilvary, CFO, British PetroleumIt all comes back to supply and demand in the world, and we still see demand strong, about 1.5 million barrel to 1.8 million barrels of new oil. And on the supply side, hopefully, we can keep up with that. About 65% of that will come from the U.S. But if we go forward with the Iranian sanctions, as I anticipate, take another 800,000 barrels off the market, long term, things are going to get tight. And so, we expect it to be pretty close going forward through the end of the year. So, oil prices are going to be strong, and hopefully we'll have a cold winter to keep us there with natural gas. – Harold G. Hamm, CEO, Continental Resources, Inc.When there are supply constraints, price tends to go up. Despite increases in production in the United States, global oil production has experienced declines, causing global oil inventories to be drawn down amid strong demand. When there are lower levels of global inventory, there is less supply available to smooth volatility in the energy market.Higher crude prices should be a positive sign for the E&P industry. However, it must be viewed in the context of the global environment. With significant differentials experienced regionally, companies are not reaping the benefit of global price improvements. Further increased volatility makes it more difficult for companies to make accurate projections, which is particularly important given the size of the capital budgeting decisions required in the industry.

I recently attended the 38th Annual National Association of Royalty Owners (NARO) National Convention in Denver, Colorado. NARO is an organization that represents the interests of oil and gas royalty owners. The group promotes education and collaboration among its members for royalty owners to better understand their minerals, what goes into the royalty checks they receive, and the future of both production and legislation for the energy industry.The conference had educated speakers who talked on a broad range of topics, and the fast-paced and engaging lectures tied together nicely. Royalty owners learned about laws and court cases currently impacting other areas that could affect them in the future. They also learned about the future of production and consumption both in the U.S. and abroad. Additionally, speakers discussed how critical phrasing included (or not included) in their lease can have an impact on the royalties they receive and the importance of advocating on their own behalf. There were even more topics discussed, some of which could have their own blog posts devoted to them, but below are the key takeaways I drew from the conference.1. Regional Regulation and Legislation Doesn’t Stay RegionalA panel on Thursday discussed current legislative initiatives in various regions of the U.S., such as a court case in Pennsylvania (Briggs v. Southwestern Energy Prod. Co. 2017) currently dealing with the rule of capture. The rule of capture means that the first person to “capture” or extract oil from the ground is the owner of the resource.[caption id="attachment_22968" align="alignnone" width="404"]Source: Marcellus Drilling News[/caption] As illustrated in the above picture, sources of oil do not fall along property lines. Even if the oil comes from a common pool that extends to another property owner’s land, common law currently says the resource belongs to whoever can extract it. The court case in Pennsylvania is challenging this ruling, as it grapples with whether or not the “extraordinary means” associated with hydraulic fracturing could cause this means of production to be deemed trespassing. In other words, because fracking requires significantly more effort to extract the oil and could pose more environmental concerns, the impact it could cause to a neighbor’s property may mean that the extraction of oil that crosses property lines could be trespassing. Another big topic was Colorado’s Prop 112 that could increase setback measures to the detriment of royalty owners in the region. As it turns out, this Proposition was defeated 57% to 43%. Regardless of the outcome of these court cases and legislative initiatives, one thing became clear at the conference: rules and regulations, like drilling, have the ability to cross borders, whether they are state lines or property lines. 2. Net Exports Doesn’t Equal IndependenceDr. Mark Cronshaw is a natural resource economist with vast experience in the industry. He discussed different ways in which energy is produced and consumed in different plays and regions in the country as well as across the globe. Of particular note, he spoke on the notion of energy independence. We can view this through the following equation:Imports/(Exports) = Consumption - ProductionFor a long time, consumption has outpaced production, requiring imports to balance the equation. However, with consumption flat and increasing production, it is anticipated that production will surpass consumption in 2022, making the U.S. a net energy exporter. Keep in mind that becoming a net energy exporter does not necessarily equate to energy independence. While horizontal drilling and fracking have had a profound impact on U.S. production, exports of LNG, coal, gasoline, etc., are vital for the economy. The U.S. may produce more than it consumes, but trade is still necessary, meaning true “independence” is unlikely.3. What’s in Your Lease and Maybe More Importantly, What Isn’tJames Holmes, Esq. is an attorney in the Dallas area with diverse experience in oil and gas litigation, operation, and investment. He spoke on post-production deductions (PPDs), which is a continuous cause of concern for royalty owners. As we discussed a while back, PPDs are the expenses incurred in order to get the gas from the wellhead to market, such as gathering, compressing, processing, marketing, dehydrating, and transporting. Royalty owners benefit when their royalty percentage is applied to the ultimate price achieved when the gas is sold in the market. However, the oil and gas companies who bear the costs of making the product marketable would prefer to deduct the expenses they incur after extracting the gas. The laws governing the deductibility of post-production expenses are different depending on location.Compared to Texas trend states, Oklahoma trend states tend to be more favorable to royalty owners.Compared to Texas trend states, Oklahoma trend states tend to be more favorable to royalty owners, as they do not allow PPDs by default. Royalty owners are protected by common law in these states, whereas Texas trend states get their best protection from well-crafted lease agreements.If a lease in a Texas trend state uses the phrase “at the well,” that means the price on which the royalty percentage will be applied is the value of production when first taken out of the ground, or “at the well.” This is before it makes its way to a refiner, where the value will ultimately be higher. Even with clauses in a lease that specifically restrict PPDs, the phrase “at the well” can act like Pacman, gobbling up all helpful clauses and leaving royalty owners with less money on their royalty checks.The differences in the two trends and the states that follow each are enumerated in the table below: While Mr. Holmes emphasized handling these issues up front, particularly in Texas trend states, we learned from another speaker that sometimes implicit beats explicit. It seems obvious that a lease contract should have everything spelled out to protect the royalty owners, but John McArthur talked about implied covenants and how they can help. Implied covenants date back to a court case in 1905 that stated, “a covenant arising by necessary principle is as much a part of the contract—is as effectually a part of its term—as if it had been plainly expressed.” Just because something isn’t explicitly stated, doesn’t mean a producer can give royalty owners the short end of the stick. In general, they must act as a prudent operator and in good faith, along with the other main implied covenants listed below. 4. Royalty Owners Need to be Self AdvocatesMany royalty owners have reaped the benefits of consistent and long-lasting production. Mineral interests tend to be passed down from one generation to the next, which distances current owners from the process that was involved with negotiating the original lease. Economic and personal circumstances change, however, and this can leave royalty owners looking for a better lease arrangement.Frequently, leases are held by production meaning once an E&P company has drilled on the property, their lease will continue as long as they continue to produce. At a certain point, further production at a well may become disadvantageous to an operator if they cannot get a good enough price in the market. The location can also be depleted to the point that it is more expensive to produce than it would be in other areas.As the saying goes, “the squeaky wheel gets the oil.”Even if E&P companies don’t intend to produce any more, however, they are not motivated to terminate a lease. The end of a lease requires companies to incur expenses that do not produce revenue, like cleaning up and leaving the site. Additionally, when a company loses access to a reserve, it is removed from the company’s balance sheet. Although production of a reserve is not economical, removal from the balance sheet can impact a key metric used to assess a firm’s value in the marketplace.Therefore, the onus is on the royalty owner to terminate a lease, which can be done if there is not production in paying quantities (an implied covenant from Garcia v. King 1942). Additionally, royalty owners can also negotiate a new lease for new production in untapped zones, even if the acreage is leased, if the current operator is unable to reach these zones. As the saying goes, “the squeaky wheel gets the oil.”ConclusionThese takeaways are only some of the topics that were discussed at the NARO 2018 Convention, which provided an excellent platform for new attendees to become informed about the industry while still being beneficial to more experienced people who have been attending the conference for years. Going for the first time myself, I certainly learned about the issues that impact royalty owners most.In order to fully understand the operations of a business, an analyst must have knowledge of all aspects of the industry. Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests.  Contact one of our oil and gas professionals today to discuss your needs in confidence.

Companies that have maintained a presence in the Bakken since the downturn in oil prices are beginning to reap the rewards of their patience. Rising oil prices have begat increases in production, and efficiencies gained in recent years have led to higher margins and increased production. As noted in last week’s post about transaction activity in the region, while the Permian Basin has received much of the attention recently, the Bakken certainly appears to be back in business.Efficient and Engaged OperatorsContinental Resources, Hess Corporation, and Whiting Petroleum Corporation are among the biggest players in the region. Whiting has rebounded with its stock price up 141% in the past twelve months, and their related royalty trust Whiting USA Trust II has also shown improved performance. Speaking of the decline in oil prices, Continental’s CEO Harold Hamm said recently, “We would never have gained the efficiencies that we have today without going through that.” This can be further illustrated by looking at breakeven prices in the Bakken, which have dropped from about $77 in September 2014 to below $39 per barrel in the third quarter of 2018, lower than those seen in Texas.Greg Hill, President and COO of Hess, recently emphasized the importance of the Bakken in their portfolio, saying about 43% of Hess’ capex budget would be devoted to the region over the next three years, targeting $1 billion annually.  He added that production constraints seen now in the Permian are very similar to those seen in the Bakken a few years ago.Infrastructure IssuesThe United States has long trailed other countries in terms of energy production.  With the leaps and bounds made in production, the question for industry executives and investors alike is now what? Increased production has led to the need for better infrastructure, a problem currently besetting the Permian basin in particular.  Extreme pricing differentials have occurred and plenty of natural gas coming off as a byproduct of oil production is being flared as a result.About 388 million cubic feet per day of natural gas was flared in June in North Dakota. Kinder Morgan, one of the largest energy infrastructure companies has proposed a $30 million natural gas pipeline that would alleviate 130 million cubic feet per day, with the project slated to begin construction mid-2019 and be finished by year-end, pending regulatory approval. Pipelines have been cast by industry executives as a safer alternative to rail transportation, though critics view this as a straw man argument. With the introduction of the Dakota Access pipeline (DAPL) in mid-2017, about half of the region's production (470,000 barrels per day of crude oil) will travel by this pipeline.  Despite the DAPL and other pipelines like the one proposed by Kinder Morgan, rail travel will still figure heavily into the equation as refiners on the East and West coast have low pipeline connectivity and much of the oil from other regions ends up with one of the numerous refiners in the Gulf of Mexico.The Minneapolis Fed recently outlined five other projects aimed at increasing gas processing capacity, including a $100 million expansion of a natural gas processing plant near Killdeer, ND. While companies seek high levels of production to take advantage of higher oil prices, these infrastructure constraints have a negative impact. Hamm emphasized this point saying, “Instead of just producing oil, we’re going to make sure we produce shareholder return.”Rig Counts and ProductionAccording to Baker Hughes, rig counts in North America declined 1.0% in the last three months, but increased 11.4% over the last twelve months. The Permian Basin has led the way with an increase of 26.2% in the past year, leading them to have 46.5% of total rigs. Rig counts peaked in the Bakken in May 2018, reaching heights unseen since 2015, but the Bakken continues to trail the Eagle Ford, Permian, and Appalachia regions. While rig counts aren’t ballooning in Bakken, this may be because operators like Continental are focusing on completing wells that have already been drilled (“DUCs”), a cheaper alternative to drilling new ones.Although oil production in the Bakken has increased 9.9% in the past year, it lagged the other four regions covered with the Permian setting the pace with a 26.6% increase. Natural gas production in the Bakken increased 17.2% in that same time, again trailing the Permian’s growth of 25.5%. Given the Bakken only produces a little over a third as much crude oil and a fifth of the natural gas, it will be interesting to see if the Permian can maintain its torrid pace or if capacity constraints will allow others to close the gap.Valuation ImplicationsBefore the crash in oil prices, the Bakken was booming with the highest EV/production multiples, also known as price per flowing barrel.  The Permian took center stage in 2017, but the Bakken is closing that gap as the Permian has come back to the pack a bit in 2018.ConclusionA rising tide raises all boats, and a rising oil price raises production in all regions. With the efficiencies gained, operators and investors in the Bakken and elsewhere will seek higher revenue and higher returns. Soaring production has led to unintended consequences such as flaring and inadequate infrastructure constraining capacity. Increasing this capacity will allow E&P Companies to increase returns and continue to ramp up production.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world.  Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

The oilfield service sector has recovered significantly since the crash in oil prices in mid-2014. As capex budgets have expanded, especially in the Permian Basin, demand for oilfield services such as drilling and pumping has increased. But what does this mean for transaction activity in the sector?The oilfield service industry was in consolidation mode over the last few years as smaller servicers struggled to survive in the low oil price environment which translated to lower day rates. Thus the relatively fewer transactions from 2015 through much of 2017 were mainly distressed sales.Now that oil prices have recovered, drilling activity has picked up, and day rates have increased, the reason for deals has changed. Rather than merging to survive, companies are acquiring in order to thrive. When discussing transactions in oilfield services sector over the past few years, maybe it should be called mergers THEN acquisitions.From Mid-2014 to Mid-2017 Oilfield Servicers Were SurvivingWhen oil prices fell, demand for oilfield services declined significantly. Despite the steep drop in prices, production did not fall through the floor because the cost of stopping and starting production can outweigh the loss incurred from lower oil prices. Still, the oilfield services sector felt the pain as many of its high value-added services occur at new sites rather than currently producing ones. With low oil prices, people became more judicious with how they deployed capital and new projects were largely tabled. Companies in financial duress were forced out of the market through consolidations and bankruptcy, as other sources of capital such as debt or additional equity offerings dried up due to the uncertainty surrounding future oil prices.M&A activity for the oilfield services sector was largely muted during the downturn in terms of both deal volume and value. Deal value would have been larger had Halliburton Company successfully completed its megamerger with its competitor Baker Hughes Inc. for an announced $34.6 billion. Instead of searching for synergies to boost revenue, companies were seeking to combine to eliminate duplicative expenses. In the case of Halliburton and Baker Hughes, the merger was expected to cut nearly $2 billion in annual costs according to the investor material seen below. Ultimately, this became the downfall of the deal as regulators denied it on grounds of decreased competition and reduced innovation on account of too much overlap in services. One year after the U.S. Justice Department blocked the deal due to anti-trust laws, General Electric bought a controlling interest (62.5%) in Baker Hughes. The combined entity resulting from GE’s investment caused GE’s combined revenue to surpass Halliburton, becoming the second largest company by revenue in the industry, trailing only Schlumberger. In early 2017, streamlining operations and eliminating expenses via consolidations was viewed as “the last big step to margin improvement,” according to the Coker Palmer Institutional. By the end of the year, there were 215 transactions in 2017, up 13% from 2016. As the tide began to turn, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings, particularly in digital technology. Oilfield Servicers Are Now ThrivingAs oil prices have recovered, up to $60 a barrel at the end of 2017 and peaking at $72 in May 2018, transaction activity has increased, but the reason for this increase in activity has changed. Companies that survived the downturn in oil prices stood to gain as rising oil prices aided margins and increased capex budgets for E&P companies. As break even prices became less of a concern for the industry, growth and innovation became the focus. Oilfield services companies depend on innovation to distinguish themselves in a highly fragmented industry, and when prices caused capital to flow out of the industry, companies were unable to fund the research and development necessary to innovate. Now, that trend is reversing with funding flowing into the sector to support growth and innovation. This is particularly important due to the capital-intensive nature of oilfield services, requiring significant investment to buy more equipment to meet growing demand.The following table shows some strategic transactions that have occurred thus far in 2018, as companies seek growth opportunities.  However, we are starting to see more investment from other sources.Private Equity Firms Are Suppling Growth CapitalAfter years of industry executives searching for diamonds in the rough, institutional investors have joined the fray. Over the last twelve months, there has been an influx of funds from private equity firms and hedge funds as growth, innovation, and fragmentation are all desirable traits for these investors.In March, Morgan Stanley Energy Partners (MSEP), the energy-focused private equity arm of Morgan Stanley Investment Management, completed an investment in Specialized Desanders, Inc. a Canadian-based oilfield equipment company that specializes in efficiently removing sands and other solids during the well flowback and production process.  MSEP’s investment seeks to accelerate growth in the U.S. market and expand their product offerings.In August, MSEP continued investing with its announcement of a partnership with Catalyst Energy Services. Proceeds from the investment will be used to buy state-of-the-art equipment which will allow the company to grow to meet increased demands for modern completion designs from E&P companies.Black Bay Energy Capital recently closed its inaugural fund with commitments of $224 million, exceeding their $200 million target.  This includes six investments in oilfield service companies exhibiting rapid growth that “improve the efficiency and cost-profile of oil & gas producers.”These investments made by MSEP and Black Bay show the three trends currently being exhibited in transactions in the oilfield services sector: niche product or specialty, innovative offering or technology, and growth. Whether it be strategic investors or private equity sponsors, acquisitions we are seeing now are largely spurring revenue growth instead of eliminating expenses.ConclusionTransaction volume in the oilfield services sector ebbed and flowed with oil prices over the last few years. On the way down, companies cut costs to survive, and mergers played an important role in increasing efficiencies in order to survive. On the way back up, companies sought capital to propel growth and fund innovation. As the market shifts from backwardation to contango and back again, Mercer Capital is here to help throughout all stages and economic environments.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help.  Contact a Mercer Capital professional to discuss your needs in confidence.

In a recent post, we explored the ins and outs of MV Oil Trust. We analyzed the underlying net profit interests it holds, the underlying properties of the trust, and the rights of unitholders including their rights during termination of the trust. This week, we will look into how these play into the composition of the MV Oil Trust’s stock price, and the balance struck between investor’s current return in the form of dividends and potential for returns from capital appreciation.Tradeoff Between Current and Future ReturnsThere is a natural friction between distributions of earnings versus reinvestment for growth. Young and growing companies tend to reinvest their earnings to fund future growth opportunities. Investors in such companies, therefore, have to be willing to forego upfront returns in hope of realizing greater returns down the road. Investors in mature companies, however, generally expect to receive dividends as a return on their investment because these companies typically have fewer opportunities for growth.Composition of Stock PriceWhile public royalty trusts are equity securities by name, they have unique characteristics that differentiate them from many equity securities. Investors typically take on exposure to equity securities for two basic reasons: receipt of cash dividends and anticipation of capital appreciation. Cash dividends are residual earnings of the Company paid to the investor at the discretion of management, and these are current returns. Capital appreciation occurs through the sale of shares at a price higher than what the investor paid, and this is a future return.Investors in public royalty trusts are typically seeking dividends. Because the investment is ultimately in a depleting asset (oil or gas reserves), capital (and therefore stock price) is expected to depreciate to zero in the long run. Many public royalty trusts, including MV Oil Trust, are restricted from acquiring more assets or interests, and most earnings are required to be paid out. These restrictions are similar to another type of trust: Real Estate Investment Trusts (REITs). Because most earnings must be distributed, dividends paid to investors would not appear to be constrained by the discretion of management, and therefore some investors consider investments in trusts to be less risky. This is not necessarily the case for royalty trusts, however, because the source of income is less stable and the ultimate level of cash distributions is dependent on the level of production set by the operator (who is not always associated with the management of the trust). Thus, investments in royalty trusts may be viewed to be riskier than investments in REITs due to this unique control structure.Let’s Get TheoreticalAccording to the dividend discount model, the intrinsic value of a stock is the expected value of future dividends, discounted back to the present at an appropriate discount rate. Forecasts of dividends are typically estimated for anywhere between 3-15 years, or until a time where future dividends will grow/decline at a stable rate. At this point, a terminal value is added, which accounts for all remaining value after earnings have stabilized, which is discounted back to the present. In the case of public royalty trusts, units of the trusts tend to hold declining intrinsic value. That is, their intrinsic value will drop to zero upon expiration of the trust agreement. This would imply no terminal value, save for the potential liquidation of assets. In the case of MV Oil, the trust will distribute the net proceeds from the sale of assets upon dissolution of the trust, so there will be a terminal value that accounts for future production remaining from the underlying properties. When a dividend is paid, the market value of the trust should decrease by the amount of the dividend. As an example, imagine a public royalty trust paying quarterly distributions of about 50¢ per share for the next two years prior to termination with a terminal value of zero. If the stock price is a little under $4.00, after accounting for the present value of these distributions, the stock price should decline by 50¢ upon receipt of the first dividend, because the stock at that point will only be worth the remaining seven distributions. Capital Expenditures ConstraintsMV Oil Trust is restricted from acquiring other properties or interests, but it will still spend money on drilling new wells on their established sites, as well as covering maintenance of currently producing wells. These maintenance expenditures may affect the quantity of proved reserves that can be economically produced. Because MV Partners has agreed to limit the amount of capital expenditures in a given year, they may choose to delay certain capital projects into the next year when the budget allows. If operators do not implement required maintenance projects when warranted, the future rate of production decline of proved reserves may be higher than the rate currently expected. So, the capital expenditure limit, implemented as a protection for unitholders, could actually have a deleterious effect.Is There Any Room for Capital Appreciation?The question then becomes, can revenue interests in an oil and gas royalty experience capital appreciation? With the requirement to pay out substantially all of its earnings as distributions and restriction on acquiring new properties or interests, it would appear that capital appreciation is unlikely. However, as we have seen in the public market, commodity price expectations can vary and change significantly in a relatively short time period. In the case of MV Oil Trust, the rebound in commodity prices and subsequent return to distributions caused the significant increase in unit price over the past two years. Even though investors are purchasing the right to obtain future distributions, buying low and selling high on the units is possible, as with any investment. For public royalty trusts, investors would need to be able to anticipate shifts in either production or price.Drill Baby Drill?Capital appreciation for royalties is not limited to the potential upside from increasing crude and natural gas prices. MV Oil Trust has drilled new wells in each of the past three years, providing investors with an upside not seen in all royalty trusts. Additional wells increase capacity which will increase royalty revenue and therefore increase future dividends, thus raising the value of the trust. Proved undeveloped reserves (PUDs) present an upside to unitholders, and drilling wells is the next step in developing these reserves, so they can eventually be produced and sold.Many royalty trusts either have not recently drilled any new wells or they do not have any proved reserves that are left undeveloped. This includes Permian Basin Royalty Trust, Mesa Royalty Trust, Sabine Royalty Trust, VOC Energy Trust, San Juan Basin Royalty Trust, and Pacific Oil Trust.Some trusts originally had upside from wells that they were contractually obligated to drill in an “Area of Mutual Interest (AMI)” when the trust was started. This includes the three SandRidge trusts, which we discussed in a recent post. Chesapeake Granite Wash Trust and ECA Marcellus Trust I also agreed to drill wells in an AMI, neither have drilled any further wells after fulfilling this requirement. Thus investors in these trusts will likely only realize capital appreciation if crude prices unexpectedly increase and stabilize at this higher price.Hugoton Royalty Trust and Cross Timbers Royalty Trust have had little to no drilling in recent years, but both benefit from having XTO Energy as an operator, who has indicated plans to drill new wells that will benefit each of these trusts.Enduro Royalty Trust, MV Oil Trust, BP Prudhoe Bay Royalty Trust, and Whiting USA Trust II have all had drilling in recent years. MV Oil Trust’s undeveloped reserves represent 14% of proved reserves, representing potential upside from future drilling. Prudhoe Bay has drilled over 100 wells in the past three years, and it has experienced the third highest 2-year return. Whiting USA Trust II has significant undeveloped acreage in the Permian, which likely plays a role in its superior 2-year return for investors.The remaining four mineral partnerships are either C Corporations or MLPs. As discussed recently, they are designed to gather assets and grow through acquisitions. Because they are not structured as trusts, they are not required to distribute a substantial amount of their earnings.ConclusionEven when royalty trusts are prohibited from acquiring more assets, investors can realize capital appreciation if oil price expectations change, the operator of the underlying assets drill more wells and/ or increase their operating efficiency, or if management expedites distributions.While the value of the underlying asset of royalty trusts (royalty interests) are expected to decline over time, there is still an opportunity for capital appreciation with commodity price changes or additional drilling. Ultimately, declining revenue distributions for private owners of royalty interests typically do not benefit from capital appreciation, but selling at the opportune time can effectively function as capital appreciation.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners.  Many publicly traded trusts have a fixed number of wells, so the value comes from declining distributions.  Some of the trusts have wells that have not been drilled, which represent upside potential for investors. The future growth and outlook potential for each type of publicly traded trust is significantly different and a potential investor would want to know the details. The same is true for a privately held royalty interest.In this post, we will explore the subject characteristics of MV Oil Trust.  This will serve as a primer for a subsequent post in which we will look further into the composition of its stock price in order to better understand investors’ ability to achieve returns through distributions and capital appreciation.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely.  The table below shows the performance and other key metrics of the 21 main oil and gas-focused partnerships that are publicly traded, as of July 12, 2018. Clearly, there were some winners and losers, with more winners than losers. Of the winners, Whiting USA Trust II (WHZT) (+243%), discussed in a recent blog post, has had the highest price return.  The focus of this blog post will be MV Oil Trust (MVO) (+99%), whose market value has nearly doubled in the past two years. For comparison, the chart below shows the two-year returns from MV Oil Trust, Crude Oil, Natural Gas, and the S&P 500.   Over the last five years, there has been significant correlation between MVO’s share price and the price of crude oil (93.3%) and less correlation with the price natural gas (74.6%). MV Oil TrustOn January 24, 2007, MV Partners and MV Oil Trust completed an IPO.  MV Oil Trust holds net profits interests, which represents the right to receive 80% of the net proceeds from all of MV Partners’ interests in oil and natural gas properties located in the Mid-Continent region in the states of Kansas and Colorado.  As of December 31, 2017, the underlying properties produced predominantly oil (99% of production) from approximately 900 wells.MV Partners is the designated operator for these properties, but they are currently being operated on a contract basis by two affiliated companies, Vess Oil Corporation and Murfin Drilling Company, Inc.  MV Partners pays an overhead fee to operate the underlying properties, which is based on a monthly charge per active operated well ($3.1 million average in the past three years).It is important to note that a majority (76% in the past two years) of the oil produced from the underlying properties was sold to a related entity, “MV Purchasing.”  The price received is based on a recent NYMEX price, reduced for differentials based on location and oil quality.  In 2017, the average differential between the benchmark and the price realized by MV Oil Trust was just under $5 per barrel.  MV Oil Trust is extremely dependent on MV Partners and its related entities.  Where this private company experiences difficulties, the trust would undoubtedly suffer, both in terms of production level and the amount it could sell.What is a Net Profit Interest?Trust unitholders receive 80% of the NET proceeds.  “Gross proceeds” are the aggregate amount received by MV Partners from sales of crude oil, natural gas, and NGLs produced from the underlying properties. This does not include consideration for sale of any underlying properties by MV Partners, nor does it include any of the oil or gas lost in the production or marketing process. “Net proceeds” represents gross proceeds, less:Payments to mineral owners or landowners, such as royalties and expenses for renewals or extensions of leases;Any taxes paid by the owner of an underlying property;Costs paid by an owner of the underlying properties under any joint operating agreement;All exploration and drilling expenses;Costs or charges associated with gathering, treating and processing oil, natural gas and natural gas liquids;Any overhead charges, including the overhead fee payable by MV Partners to Vess Oil and Murfin Drilling; andAmounts reserved for approved capital expenditure projects (up to $1 million per 12 months), including well drilling, recompletion and workover costs. Unitholders are entitled to quarterly cash distributions of substantially all of the trusts quarterly cash receipts, less the trust’s expenses and any cash the trustee decides to hold as a reserve against future expenses.  As noted above, the trust’s share price is highly correlated with the price of oil because the trust is ultimately as valuable as the distributions it makes.Termination of the TrustUnlike a traditional royalty interest that continues into perpetuity, a net profit interest in MV Oil Trust will terminate on the later of:June 30, 2026, orThe time when 14.4 MMBoe have been produced and sold (equivalent to 11.5 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties) As of December 31, 2017, the trust had received payment for approximately 8.0 MMBoe of the 11.5 MMBoe interest, or about 70% of the termination threshold. The trust will dissolve prior to its termination if it sells the net profit interest or if annual gross proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years.  Upon dissolution, the trustee would then sell all of the trust’s assets and distribute the net proceeds of the sale to the trust unitholders.Underlying PropertiesThe underlying properties are in Kansas and Colorado, or the Mid-Continent region, which is a mature producing region.  Most of the production consists of desirable light crude oil.  Most of the producing wells are relatively shallow, ranging from 600 to 4,500 feet, and many are completed to multiple producing zones.  In general, the producing wells have stable production profiles with total projected economic lives over 50 years and an estimated average annual decline rate of 8.6% over the next 20 years.  This extended shelf life is attractive for unitholders of the trust because even though the trust is expected to terminate, the unharvested production capacity can still be sold.As seen in the tables below, the majority of proved reserves are developed, oil reserves.  Also, the majority of acreage is in either the El Dorado or Northwest Kansas area. The majority of the net operated wells are oil wells; however, there are also some non-operated oil wells.  In the past three years, each Trust has added to its well count by drilling additional development wells.  Most of these occurred in 2016 when 7.6 net wells were drilled.  These additional wells increase production capacity and thus potential for future distributions. Other Rights of Trust Unit HoldersNet proceeds received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets.  Unitholders will be compensated if a sale occurs.  Further, the trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders.  This sale also cannot exceed a fair market value of $500,000.  This protects unitholders from having significant assets sold in any given year, which would decrease the level of future production.As mentioned earlier, capital expenditures are currently limited to $1 million per 12 months.  These expenditures are further limited after the “Capital Expenditure Limitation Date.” This is defined as the later of:June 30, 2023, orThe time when 13.2 MMBoe have been produced and sold (equivalent to 10.6 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties) On this date, capital expenditures are further limited to the average of the prior three years of capital expenditures, which will likely drop it considerably below its current limit of $1 million per year.ConclusionIn our next post, we will use MV Oil Trust as a basis for examining how investor returns are affected by a royalty trust’s distribution of proceeds, volatility in the price of crude oil, the timing of entrance and exit, and other unique features of the royalty trust such as limits on capital expenditures.  We will do this by looking into what goes into the stock price of royalty trusts and the tradeoff between current and future returns.When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust.  The source of income, region, operator, termination, and other key aspects make each trust unique.We have assisted many clients with various valuation and cash flow questions regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Capital IQ

Production in the Permian is as hot as the summers in West Texas.  Despite being discovered in the 1920s, it was not until 2007 that the region’s true potential was realized when hydraulic fracturing techniques were used to access the play's tight sand layers. Given its low-cost economics and large well potential, in recent years, the Permian has been in the limelight with operators and investors alike prioritizing the region.According to Baker Hughes, there are virtually no active gas-directed rigs, but significant gas production is still occurring in the region because natural gas is coming as a by-product from the oil rigs.  As we discussed in a previous post, this is having a negative effect on natural gas prices and producers outside of the Permian.  Companies in the Permian have an advantage because they do not have to choose between oil and gas, and production is more efficient.  As such, the Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus.Rig Counts and ProductionWith many producers clamoring for a piece of the action, the number of rigs in the Permian has consistently grown at a faster rate than total rig counts in the country.  As a result, the Permian has increased its share of total rig counts, as seen in the graph below.  In June 2015, the Permian accounted for 27% of all rigs, but that number steadily increased to 45% as of June 2018.  The number of rigs in the Permian has grown 32% in the past year, compared to 16% nationally; these figures were 156% and 125% for the year before that. According to the EIA, production of oil and natural gas in the Permian Basin has increased at a compound annual rate of 25.0% and 21.1%, respectively over the last five years.  In the past year alone, oil production increased 35.6% and gas production increased 26.5%, with over 45% of the U.S.’ crude oil and 15% of the country’s natural gas currently coming from the Permian Basin.1  A concerted effort has been made to increase efficiency, which has led to a rise in production per well.  Oil production per rig in the Permian increased more than 36% in the last year, which, when combined with the rise in rig count, further emphasizes the focus on the region. Economic ImpactWith this rush to West Texas, Midland and Odessa are in the middle of the action.  The boom has had a large impact on their economies as a whole.  Population growth from 2016 to 2017 was estimated at 4.2% for Midland and 4.8% for Odessa, compared to 2.0% for Texas and 0.8% for the country.  Unemployment was also extremely low at 2.1% and 2.8%, respectively, compared to 3.8% for the state and 3.7% for the country.  The national unemployment rate is already at its lowest of this millennium, emphasizing how razor-thin the margin is in Midland.  This has caused significant labor shortages in other sectors of the economy as they cannot compete with $28/hour wages offered after minimal training requirements for workers in the oil sector.Valuation ImplicationsWe can understand the valuation implications for companies in the Permian Basin by looking at 1) royalty trusts and mineral rights aggregators and 2) E&P companies.Royalty TrustsPositive market sentiment for the Permian region can be viewed in the performance of both operators in the region and publicly traded royalty trusts with exposure to the Permian.  As seen in the following tables, royalty trusts in the Permian have seen far superior two year returns.  Also of note is the average size measured by market cap.  Viper Energy Partners, Black Stone Minerals, and Kimbell Royalty Partners are all aggregators of mineral interests and are not restricted from acquiring new interests like many other royalty trusts.  This causes them to be larger, and it also allows them to gain exposure to new, advantageous regions, which may play a role in all of them having exposure to the Permian. Royalty Trusts typically decline in both production and level of reserves. For the trusts with properties outside of the Permian, they have averaged decline rates of 14% for production and 21% for reserves over the past three years.2  However, trusts in the Permian are increasing at average rates of 13% for production and 7% for reserves.  This indicates the increased activity in the region, though again, it should be noted that some of the trusts that are not restricted from acquiring new properties are likely to be categorized in the Permian group as they would have sought exposure to the region. E&P CompaniesAs seen in the graph below, E&P companies valuation multiples on average remain highest in the Permian, but they have declined 21% in 2018.  Multiples in the Bakken and Eagle Ford meanwhile have cut into the gap, increasing 34% and 25%, respectively since the beginning of the year.  The Marcellus and Utica continue to see the lowest valuation multiples and have declined by 2% in 2018.  Companies in the Permian are generally more profitable than companies in other regions as explained by their lower break-even prices. According to Bloomberg Intelligence, recent break-even prices in the Permian were $38 in both the Delaware and Midland Basins.3  This represents a 6% decline for the Delaware Basin since June 2017, compared to a 28% decline in break-even price for the Midland Basin.  These break-even prices compare favorably to $40 in the Bakken and about $44 in the Eagle Ford. Production in the Permian appears to be full steam ahead. And as they say, if you can’t stand the heat, stay out of the Permian. We have assisted many clients with various valuation needs in the oil and gas space in the Permian region, other conventional and unconventional plays in North America, and around the world.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Notes1 EIA; Calculations based on monthly crude oil and gas production and EIA drilling report by region 2 Capital IQ; Calculations based on production and reserve figures reported in royalty trust 10-K’s 3 Bloomberg Intelligence; County Level Estimate

In previous posts, we have discussed the market pricing implications of publicly traded royalty trusts to royalty and mineral owners. We have explained the importance of understanding the specifics underlying those trusts before using them as a pricing benchmark. In this post, we will delve further into market prices of royalty and mineral interests and the important role of operators. We will look into the three publicly traded royalty trusts operated by SandRidge Energy: SandRidge Mississippian Trust I, SandRidge Mississippian Trust II, and SandRidge Permian Trust.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely.  Thirteen have experienced positive market value returns with an average of positive 57% and eight have returned market value losses during the previous two years with an average market value return of negative 39%.Clearly, there are some winners and losers, with more winners than losers. The royalty trust with the highest market value return was Whiting USA Trust II (WHZT) (+330%), which was discussed in a recent blog post.  Mesa Royalty Trust (MRT) (47%) was another big winner covered in a previous blog post.  However, the focus of this blog post will be on some of the underachievers: SandRidge Mississippian Trust I (SDT) (-76%), SandRidge Mississippian Trust II (SDR) (-61%), and the SandRidge Permian Trust (PER) (-21%).For comparison, the chart below shows the returns from PER, SDR, SDT, crude oil, natural gas, and the S&P 500. Why has the value of these SandRidge Trusts depreciated so much over the past two years despite increasing commodity prices? Also, why has the Permian trust fared better than the Mississippian Trusts? Below is a discussion of the assets, underlying properties, and agreements of each Trust. SandRidge Mississippian Trust IThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:90% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 36 wells producing at December 31, 2010, and one additional well undergoing completion operations at that time (together, the “Initial Wells”).50% of such proceeds from 123 “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill, or cause to be drilled, the Trust Development Wells by December 31, 2015.  SandRidge fulfilled this obligation in April 2013. SDT’s Royalty Interests are in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Garfield, Grant, and Woods counties in northern Oklahoma.SandRidge Mississippian Trust IIThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 54 wells producing at December 31, 2011, and 13 additional wells awaiting completion at that time70% of such proceeds from 206 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by December 31, 2016.  SandRidge fulfilled this obligation in March 2015. SDR’s Royalty Interests are in specified oil and natural gas properties also located in the Mississippian formation in Alfalfa, Grant, Kay, Noble and Woods counties in northern Oklahoma, as well as Barber, Comanche, Harper, and Sumner counties in southern Kansas.SandRidge Permian TrustThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 517 wells producing at April 1, 2011, and 21 additional wells awaiting completion at that time70% of such proceeds from 888 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by March 31, 2016.  SandRidge fulfilled this obligation in November 2014. PER’s Royalty Interests are in specified oil and natural gas properties in the Fuhrman-Mascho field in Andrews County, Texas, which is a part of the prolific Permian Basin. It should be noted that this is outside the two main Permian sub-basins (the Delaware Basin and the Midland Basin). Nevertheless, the Permian's attractive location and increased well count likely explains why the Permian Trust outperformed the Mississippian Trusts. The following table shows important production and reserve data for the underlying properties, as well as SandRidge’s ownership in the Trusts’ units and other pertinent data. The Trusts no longer have any hedging derivatives contracts, so they are exposed to oil and natural gas price volatility. Analysis of TrustsDevelopment Wells and Area of Mutual InterestEach of the Trusts receives 80-90% of the proceeds from the sale of oil, natural gas, and NGLs (after deducting post-production costs and any applicable taxes). This is fairly common for publicly traded royalty trusts, but the Trust Development Wells are unique. At the IPO date for each Trust, well counts were relatively low. In fact, the initial wells made up less than 25% of the total well counts for the Mississippian Trusts and about 38% of the Permian Trust. This agreement allowed the Trusts to make distributions from currently producing wells in addition to offering growth opportunities with the future development wells.The “development” aspect of the wells would seem to cast doubt upon the production of each Trust if it did not end up developing the total number of wells required or in a timely manner. The development agreement offered protection to investors. It is important to note that SandRidge fulfilled its development obligation in plenty of time in each case. Investors were further protected with the clause ensuring wells would be drilled in an area of mutual interest (AMI). This means SandRidge could not drill wells in random locations to fulfill its obligation.DistributionsThe Trusts make quarterly cash distributions of substantially all of its cash receipts, after deducting amounts for the Trusts’ administrative expenses and cash reserves withheld by the Trustee. The price for oil peaked in 2014 near $108 per barrel and close to $8 for natural gas before declining sharply in the latter half of the year. The low point was seen in late 2015, early 2016, with prices of approximately $28 and $1.64, for oil and gas.  Prices currently stand around $68 per barrel and $2.80 per MCF, respectively. The steep decline in oil and gas prices in mid-2014 had a crippling effect on distributions.  The following chart tracks the quarterly distributions per share for the Trusts since 2012.Termination of the Trusts The Trusts will dissolve and begin to liquidate on the “Termination Date” (noted in the table above). At the Termination Date, 50% of the Royalty Interests will revert automatically to SandRidge. The remaining 50% of the Royalty Interests will be sold at that time, and the net proceeds of the sale, as well as any remaining Trust cash reserves, will be distributed to the unitholders on a pro rata basis. SandRidge has a right of first refusal to purchase the Royalty Interests retained by the Trust at the Termination Date. There are certain provisions protecting investors in the case the Trust were to dissolve prior to the Termination Date, such as a requirement that cash available for distributions be above a certain threshold, as noted in the table above. The Trusts are highly dependent on its Trustor, SandRidge, for multiple services including the operation of the Trust wells, remittance of net proceeds from the sale of associated production to the Trusts, administrative services such as accounting, tax preparation, bookkeeping, and informational services performed on behalf of the Trusts. For these administrative services, the Trusts pay SandRidge an annual fee (noted in the table above) which is payable in equal quarterly installments and will remain fixed for the life of the Trusts. SandRidge is also entitled to receive reimbursement for its out-of-pocket fees, costs, and expenses incurred in connection with the provision of any of the services under this agreement. SandRidge Energy and the Importance of the OperatorSandRidge Energy (SD) is an oil and natural gas exploration and production company headquartered in Oklahoma City. According to SD's website, its principal focus is on developing high-return, growth-oriented projects in the US Mid-Continent and Niobrara Shale.SandRidge filed for Chapter 11 bankruptcy in May 2016 and emerged from bankruptcy in October 2016, as we discussed in a blog post around that time.  SandRidge was relisted on the NYSE around $19.50 per share. Its performance has been volatile and generally negative since, as seen in the chart below. Activist investor Carl Icahn spent $82 million in October and November 2017 to acquire about 13.5% of SandRidge stock.  Since he became a shareholder, Icahn has had a large impact, causing directors to cancel their planned $746 million purchase of Bonanza Creek Energy and lay off 80 employees including their CEO and CFO. He also played a role in the rejection of an acquisition attempt by Tulsa-based Midstates Petroleum Inc. in February. Icahn recently expressed "grave concerns" with the board, claiming it had “a history of making poor decisions on behalf of stockholders.” Market confidence for SandRidge Energy is very low, after having gone through a bankruptcy-related restructuring recently as well. These concerns are significant to the SandRidge Trusts because operators play a vital role for royalty interests. They are responsible for production, without which, there are no distributions. If an operator is unable to produce or becomes less focused on a particular well or region, the royalty interests attached to them are worth significantly less. In the case of the SandRidge Trusts, turmoil with the operator has put future production into question. The lack of control for the royalty interests means they are tied to the fortunes of the operator. Even for securities with yields above 20%, the unsustainability of these distributions does not inspire confidence in investors. ConclusionThe operator is a key consideration for owners of royalty interests, particularly those interested in selling. As outlined in our post last week, offers received for royalty interests can be heavily dependent on operators and the uncertainty related to a change in operator.Owners of mineral interests typically receive offers as multiples of average monthly revenue received.  These multiples are typically determined by commodity prices, quality of operators, growth opportunities, and market sentiment. While owners of royalty interests do not have much control over these factors, they provide important starting points when considering selling.We have assisted many clients with various valuation and cash flow questions regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQ