The deal came more quickly than we anticipated. But the key is that we saw an opportunity to buy a premiere brand [BMW], with a great local brand name (Chandlers), in the second highest demographic region of the country. And felt it was a great business proposition."
- Earl Hesterberg, Group 1 CEO, on yesterday morning's conference call about the company's first international (auto retail) acquisition.
Group 1 (NYSE:GPI) announced yesterday morning they acquired Chandlers Garage Holdings in the southeast part of England. According to United Kingdom government's statistics website (mid-2005 population trends report), the Southeast region is estimated to grow 13% from 2004 to 2029. Not as good as London's expected 19% growth, but still up there as one of the faster growing regions in the country.
Now aside from pointing out the 3 BMW stores (6 franchises as each store has a Mini franchise also) should add about $180 million in annual revenues, I think you are very capable of reading the press release, so I won't regurgitate.
Instead, I want to tell you about the movie Kingdom of Heaven. Toward the end of the movie, Bailian, a knight that was defending Jerusalem had just reached a truce (safe passage) from the Muslim army who had defeated them. And after watching so many lives lost (on both sides) over the city of Jerusalem, Bailian asked the leader of the Muslim army (Saladin), what is Jerusalem worth? Saladin said in a rather nonchalant (casual) manner: "Nothing," and began walking away. But then he stopped, turned around, and putting his fists together by his chest and with a smile said: "Everything!"
So what does Group 1's acquisition of the Chandler Group mean? What is it worth?
Nothing. . .
Group 1's 2007 earnings guidance at the end of the 2006 was for $4.00 to $4.25 in earnings per share. The guidance excluded future acquisitions. Yet following yesterday's announcement management updated their investor presentation slides on the company's website so it now includes the Chandler Group and a map showing Group 1's international footprint. But the guidance (slide) remained unchanged. So right off the bat, investors should not expect this to have a meaningful impact on earnings. Let me give you some numbers to go along with this thought. . .
During the conference call, Group 1's CEO Earl Hesterberg said that BMW dealership groups that rank in the top quartile (so best one out every four) in the United Kingdom generate pre-tax return on sales of ~3%. This means for every $100 in sales, before you pay "Uncle Sam," or in this case "Mother England," you can put $3 of that sale into the bank.
Management would not say if the Chandler group ranked in the top quartile of BMW dealerships in the U.K. However, they did say that while the Chandler group is very profitable, whenever Group 1 buys a dealership they expect to make improvements.
So whether Chandler is in the top quartile today, or Group 1 brings them there, clearly the bogey (target) is for pre-tax profits of ~3% of sales. Now as an analyst, this should give you a pretty good idea what the acquisition can mean to earnings in the near/intermediate term. You simply take 3% of the $180 million in annual revenues, and come to the conclusion that the potential is ~ $5+ million in annual pre-tax profits.
However, unless Group 1 Management plans to stage another Boston tea party, they need to pay the English government taxes on Chandler's earnings. So on an after-tax basis, we're talking a little more than $3 million, which nets out on a per share basis (assuming about 24 million shares), to a little more than a penny a share in additional earnings.
Now the acquisition happened in March (so you don't have a full year). There were some one time due diligence and "market entry" expenses. And we don't know how long it will take the company to get to the 3% bogey (if not already there). And keep in mind, we're only talking a penny here when management has a $0.25 delta (difference) between the top and bottom end of their 2007 earnings guidance. Bottom line? It doesn't mean squat to earnings.
The auto industry is a global business, and over the course of the next several decades, global automakers will need global partners to distribute their products. It is an inevitability (I think) that all of the large dealership groups over time will need to become global players.
If you examine GM (NYSE:GM), Ford (NYSE:F) and Chrysler's (DCX) restructuring plans (well assuming Chrysler remains a part of Daimler), they all call for greater (global) integration. Think back to Rick Wagoner's (GM's CEO) comments to analysts at the Detroit Auto Show in January. Remember how I outlined Mr. Wagoner's top 5 priorities? Here's number 3:
3). Continue to drive the benefits of running the business globally. Mr. Wagoner said this is probably one of the most profound changes at GM as they become one global product development, design driven company. Bob Lutz, the company's Vice Chairman spent a lot of time emphasizing the transition that has taken place at the company from an amalgamation of four different companies, while today they have centralized product functions, with global design and global engineering.
Ford emphasized something similar with their investor presentation. And I can tell you that having sat through a presentation by Peter Weiss (Director of Daimler's worldwide transportation & customs, procurement and supply) not too long ago, their restructuring plans entail a similar global collaboration and approach to the business.
Of course, it will depend on whether they keep Chrysler. The only thing I will say about that is, doesn't it strike you as odd that DaimlerChrysler would announce a restructuring plan that integrates Daimler and Chrysler much more than today, and then they start talking about selling it off? I hope you noticed that after DaimlerChrysler announced their restructuring plans, the UAW articulated concerns with the plan. So maybe this is really a way of DaimlerChrysler saying to the union, either you allow these restructuring plans at Chrysler, or we don't need to own it?
Importantly, the push (now more than ever) at the automakers is to become more globally integrated. And while the automakers are (and have been) looking at it on the supply/production end today, over the next 5 - 10 years I suspect they will begin looking at it on the distribution end.
In almost every business you learn real quick that the more relationships you have to manage, the more difficult it is to ensure consistency. And the only way the automakers can help ensure consistency (brand message, customer service, etc). is to partner with fewer, but better (and likely bigger) distributors. The key begins with being better (not bigger). Once you are better, however, obviously you get included in the "fewer" distributors the automakers are dealing with, and by default should become bigger.
Large dealership groups that have proven they will invest in the business and create a positive customer experience should (in theory) be easier and a more efficient channel to deal with. So Group 1's announcement yesterday is simply a first step in becoming a global partner with these global manufacturers.
Sounds great. Everyone should do it, right? Not so fast. . .
What can go wrong? Getting ahead of yourself
During the conference call Group 1's CEO Earl Hesterberg and CFO John Rickel candidly said that the expansion into an international market came faster than they anticipated. But as you saw in today's opening quote that:
the key is that we saw an opportunity to buy a premiere brand [BMW], with a great local brand name (Chandlers), in the second highest demographic region of the country. And felt it was a great business proposition.
Mr. Hesterberg also said on the call that they felt no rush to get greater scale in the U.K. market. Essentially, that if need be, this group could simply sit there on its own for another year or two. I think this might be a good idea.
Don't get me wrong. Like I said above, over time I think all of the major distributors will need a global footprint. But the United Kingdom is not like buying a store in Montana. The dynamics of the dealership world over there are very different. One where the efficient thrive and the not so efficient go home with zero goodwill (blue sky). So if you don't know what you are doing (or have the right team in place that does) you can really get your head handed to you.
Two other auto retailers appear to be successfully pursuing a global strategy. Coming from the United States, United Auto Group (NYSEARCA:UAG) is probably the leader in terms of being a global auto retailer, with more than 30% of their profits coming from abroad. On the other side of the pond, Pendragon, the largest auto retailer in the United Kingdom, Pendragon has been quietly buying stores in California. But dealerships outside of the United Kingdom still represent only something like 5% for Pendragon, so they are "sort of" a global auto retailer.
And if anyone has a good chance of following in UnitedAuto Group and Pendragon's footsteps (of not getting their head handed to them), it is Group 1's management team. Keep in mind, Earl Hesterberg and John Rickel have pretty extensive experience in the European automotive market (from when they were at Ford). I believe they even had oversight responsibility at one point for Ford's company owned stores in Europe. So they clearly have a good understanding of what they are getting into.
Seven differences between U.K. and U.S Auto Retail Market
But if any of you are shareholders (or maybe even employees) and don't have a good idea of what you are getting into, I thought I would share with you at least what I know about the U.K. auto retail market.
For the record, I toured some dealerships (United Auto Group's Sytner Group) in the U.K. [ONCE], watched Trevor Finn (CEO of the U.K.'s largest dealership group Pendragon) present to dealers/investors [ONCE], and have had some limited conversations with industry participants and consumers in the U.K. market. So I can hardly claim to be an expert in U.K. auto retail.
But here are just a few of the differences I think analysts need to be aware of between the U.S. and the U.K. market:
1) Not as urban as you think
When I think of England, London pops right into my mind. So to be honest, I didn't think a lot of people in England owned cars, because I thought it was rather "urban." I love how ignorant someone like me can get and not really try to understand a market outside of my present surrounding (you mean everyone doesn't live on the beach?)
But I happened to be down in Miami last week crashing a finance meeting with folks from British Petroleum (actually a friend invited me out), where a couple people who lived in the U.K. told me that in London it is mostly "short timers" (a lot of foreigners) that actually live in London and don't own cars. Most of "us" (U.K. residents) I was told live outside London and take the "tube" to work, and therefore "drive our kids to school and have a vehicle on the weekend."
2) 6 or 7 vehicles per every 10 people in UK
So, contrary to my initial belief, it seems like there are a fair amount of British people who own cars. In fact, if you take the European Automobile Manufacturers Association [ACEA] data of Great Britain having 29.8 million passenger cars (33.56 million total vehicles in use), and divide it by the roughly 49 million British citizens over the age of 16 (according to the British Government's national statistics web page), you see there is a passenger car (in the population) for roughly 6 out of every 10 people in Britain (that are of driving age). And if we included all vehicles (including commercial vehicles), you come closer to 7 out of 10. But that is still not at U.S. levels.
In the U.S. you've got about 300 million people in the population, with roughly 240 million of these individuals over the age of 15 (about as comparable as I could get it). So if you divide the roughly 237 million total vehicles (probably 215 - 220 million light) on U.S. roads, you end up with somewhere between 9 - 10 vehicles out there for every 10 "eligible" driver in the U.S.
3) Probably 1 vehicle per licensed driver in UK
I could not find a vehicle per licensed driver statistic (like we have in the U.S.), but you should keep in mind that about 10 million British citizens (about 16% of the total population) are over the age of 65. So you also probably have a fair amount of older citizens that are no longer able to drive. My guess then is that the number of vehicles per licensed driver in the U.K. (despite bustling urban populations like London) is closer to 1:1.
Although in the U.S. (when I tally the census data) you've got some 36 million folks over the age of 65 (more than 12% of the population), which is why you end up with roughly 200 million licensed drivers, or roughly 1.2 vehicles per licensed driver (at least according to data from the Department of Transportations National Center for Statistics and Analysis).
This is why I get so nervous when we (U.S. citizens) consider the US census bureau forecasts that suggest the U.S. population is headed toward 16% of its citizens being over the age of 65 in 2020. Will they (U.S.'s aging population) need to drive as much? Although one encouraging point on this, is that at least in the U.K., despite their aging citizen population, their vehicle population growth over the last 5 years has actually exceeded the U.S. vehicle population growth (as I discuss below).
4) Used purchasing dynamics likely different than US
In total, last year (according to Pendragon's annual report) there were about 10 million new and used vehicles sold in the U.K., which is about a fifth the size (a little less ~17%) of the entire (new and used) U.S. vehicle market. More than 70% of the U.K. market is used, at least when I take into consideration the 2.3 million new vehicle units registered in the U.K. in 2006 (thanks ACEA for the data).
In the U.S. you've similarly got about 70% of the market (40+ million out of the ~60 million total units sold in the United States last year) consisting of used vehicle sales. But there are a couple differences in new and used in the U.K versus the U.S. I think this is particularly important when you hear Group 1's management team highlight the 0.8 to 1 used to new vehicle ratio at the Chandler stores, which is higher than the ~0.7 (retail) used to new (industry) ratio in the U.S. I calculate from the NADA 2006 data book. I heard the same thing from UnitedAuto Group, and I think that while the markets (at first blush) of used/new purchases between the U.S. and U.K. appear similar, they really are not.
I think it goes beyond just the "definitional" problems of new and used vehicles in the US versus the U.K. where a lot of "demo" vehicles gets counted as used vehicle sales in the U.K. I think there is a different consumer purchasing pattern going on in the U.K market versus the U.S. that drives the higher used/new ratios in that market.
Let me explain. In Great Britain, you've got about 33.5 million total vehicles in use as of 2005, which is about 10% more than the 30.5 million units they had in 2000. So if I take the 10 million (total new and used) units Pendragon says were sold in 2005, it means they are "churning" about 30% of their entire vehicle population a year. Or another way of thinking about it is that a little less than one out of every three vehicles in the U.K. vehicle population (new and used) are sold every year.
In the U.S. the vehicle population (according to the U.S. Federal Highway Administration) has grown 9% from 2000 to 2005 from 217 million to 238 million, not too different from the U.K. But when I divide the roughly 60 million units by the 238 million units in the U.S. vehicle population, I only come up with a "churn" rate of 25%.
This may seem subtle, however, what it means is that in the U.S. it takes roughly 4 years to turn over the entire vehicle population, while in the U.K. it takes only 3 years. Or to more bluntly say it, U.K. citizens get bored quicker with their existing models, creating a higher turn and why you likely see a higher used/new ratio at U.K. dealerships versus in the U.S.
Having said that, you similarly see Pendragon (the U.K.'s largest dealer) looking for better results as they enter the U.S. market. In Pendragon's 10k when discussing their used vehicle sales at their California stores, they said:
A significant difference is the lower proportion of used car gross profit due to a traditional emphasis on new car sales in this market.
They've got Jaguar, Land Rover, Aston Martin and Saab franchises in Southern California. I'm not sure if these brands typically focus on new sales, but I think it can prove kind of an interesting test to watch and see if the Pendragon management team is able to improve the used to new mix in their California stores.
5) Block exemptions have caused rapid consolidation
A few years ago the European Union passed new regulation that removed the ability to grant "blocks" or exclusive territories between automakers and retailers. As a result, manufacturers wanting to protect their brand rights, but not being able to grant exclusive territories, placed serious requirements (customer satisfaction, facility upgrades, etc) on dealers if they wanted to represent their brand. Dealers unable or unwilling to invest in these requirements have been exiting at a pretty quick clip (a lot of times at zero goodwill).
Along those lines (because of the block exemptions), I think this has driven a massive wave of consolidation in the market. The haves/have nots (of systems and processes) you constantly hear me talking about. According to Auto Industry (a U.K. based auto info website) the number of vehicle sales companies (auto retailers) have declined 34% from 36,383 in 1996 to 23,936 in 2005.
In the U.S., on the other hand, the rationalization has been much slower. Total new car dealerships in 1996 were 22,750 (according to NADA data), while in 2006 there were 21,495, a mere 5.6% decline in total dealerships (compared to the 34% drop in U.K. dealerships). One caveat, I may be comparing apples and oranges because the U.K. figure includes used dealers.
But even if I were to add the number of independent dealers in the U.S., to get an "apples to apples" comparison, I just don't see the drop off. According to the 2002 US census data, there were 51,731 automobile dealers, up from the 49,237 the census data says existed in 1997. Granted, I think there's some definitional and data gathering challenges that exist when trying to measure establishments. But almost every data point (and anecdotal comment I hear) suggests the U.K. market is rationalizing a lot faster than the U.S.
The bottom line as many dealers (in the U.S). tell me:
"Jerry, we all recognize there are too many dealerships (that the market is 'over dealered.') But everyone wants to get to heaven, only no one really wants to die to get there!"
In other words, people aren't going to give up their dealerships until some "event" causes it. In the U.K. this was a regulatory event (removal of block exemptions) that created an economic decision to exit (entrepreneurs not wanting to invest in store improvements), Whereas, in the U.S. the "event" may be straight up "economics" eventually causing the rationalization. But the market will rationalize (or so I argue). It is only a matter of how long it takes for economics to work its course.
Having said that, I shouldn't be too tough on U.S. dealers, they're actually more efficient than I give them credit for. . .
6) Dealer throughput a lot lower in UK and I can't explain why!
If I take the 16.5 million light new vehicles sold in the United States in 2006 (according to BEA and Ward's data) and add the 11.8 million used vehicles sold (retail) by franchised auto retailers (according to the NADA), I come up with roughly 28.3 million new and used units retailed in the United States by franchised auto retailers last year. Dividing these numbers by the 21,495 dealerships in the U.S., I come up with roughly 768 new units being sold at each franchised auto retailer last year, and 549 used units retailed (hence the 0.7 used to new ratio). In total then, I come up with 1,317 new and used units sold per franchised auto retailer in the U.S. And if I divide the roughly 60 million of total new and used vehicles sold a year in the U.S. by the 51,731 total automobile (new and used) dealers in the U.S. (once again to keep an "apples to apples" comparison, I come up with roughly 1,160 units sold per store.
In the U.K., I don't have as granular (new/used) break out, but just taking the 10 million (new and used) units sold last year and dividing it by the 23,936 dealerships Auto Industry says are out there, you come up with only 418 vehicles sold a year. Even the largest (and arguably one of the best) auto retailers in the U.K., Pendragon, I calculate given their 390 franchises and 305,000 units sold in 2006 only did about 783 units a franchise.
Armed with this insight, I think it raises a good question. Why do the U.K. stores seem less productive on a throughput basis? The profit metrics, at least out of the public dealer groups in the U.K. would not suggest they are inefficient (if anything I think they lead the globe in efficiencies). For example, when I asked about back office consolidation at Chandler, Mr. Rickel said that Chandler had already consolidated accounting functions to a single location. And as Group 1 brings scale, I suspect they won't be far behind in following Sytner and Pendragon with having a centralized call center for service appointments and customer relationship management.
My general thinking is that the U.K. landscape is more spread out, and so you end up with smaller dealerships. I can tell you this is what I observed when I toured Sytner's dealerships. It sure helps explain why Group 1's acquisition of only three BMW dealerships results in them owning two collision repair centers. CFO John Rickel explained it to me that it is simply more economical to have one on each end of the region.
But I have to admit, the population data between the U.S. and Britain suggests a fairly similar landscape. At least according to a Brookings Institute report in 2005 that compares U.K. metropolitan markets versus the U.S. In the report they say the top 20 U.S. metro areas contained 30.6% of the population, while English "mets" contained 30.1% of the U.K. total. So not very different. Although the Brookings Institute report does say the top 20 U.S. cities contained 10.7% of the national population, while the 10 U.K. core cities encompassed just 8.5% of the population.
However, this is a misnomer (smaller stores and lower throughput) in the U.K. dealerships versus the U.S. that I just can not explain (from a demographics standpoint). It may also be why the U.K. market is consolidating at a faster clip. But, I think it goes far beyond store throughput.
True pre-tax profits (as I outline below) are lower, but not that much lower. And the growth rates are even higher (at least out of Pendragon). So I think we can look at the U.K. market as a great example of how some shift in the environment (i.e. block exemptions) can spark a massive consolidation wave (because ultimately it creates an economic reason to exit). But (as I have been trying to emphasize) I think we need to recognize that the store model in US is very different from UK dealerships (where you've got lower throughput, but if run well like at Pendragon still attractive returns).
So moving into the international scene (even one like the U.K. that is probably as close to the U.S. model as you get), is not a decision that should be taken lightly. An important strategic move? You bet. But I can not be more blunt when I say if you do not know what you are doing, if you do not understand the market, or REALLY know the person you are putting in charge, you are likely to get your head handed to you.
7) Profit metric differences
So let me give you an idea of the store metrics in the U.K versus US stores. For this I think the best "profit picture" comes from looking at Pendragon's 2006 annual report (the largest dealer in the U.K). So here's the break out:
Roughly 47% of Pendragon's luxury brand (Stratstone) revenues came from new vehicle sales, 36% used, 10% after sales, and 7% trade cars.
The company's high volume brand (Evans Halshaw) revenue composition was 45% new, 27% used, 11% national fleet, 4% trade cars, and 3% wholesale.
In the U.S. the closest I can come to for a luxury brand is Asbury. In 2006, they had 60% of their revenues come from new vehicle sales, 25% come from used, 12% parts and service, and 3% finance and insurance (F&I).
As far as a "high volume" comparable, I think the best would be AutoNation. In 2006, they had 59% of their revenues come from new vehicle sales, 24% come from used, 14% parts and service, and 4% finance and insurance (F&I) and other.
Gross Profit Mix
Once again, for Pendragon's luxury brand. Roughly 36% of Stratstone's gross profits come from new vehicle sales (with 10.1% gross margins). 20% of gross profits come from used vehicle sales (7.3% gross profit margin), 45% of total gross profits come from aftermarket sales (with a 58.1% gross margin), and trade cars actually hurt total gross profit by 1% (with a negative 1.2% gross margin). Keep in mind, you have some "demo" (basically new vehicles) being sold as "used." And also, you've got a "value added tax" issue that hurts used vehicle gross margins. But get this, when you convert Stratstone's gross per unit into U.S. dollars, you come up with them generating nearly $3,500 in gross per unit.
Evans Hall, Pendragon's high volume brand, in 2006 got 25% of its gross profits from new vehicle sales (with a 7.2% margin), 34% of its gross profits from the used business (16.6% gross profit margin), 41% of its gross profits from aftermarket sales (49% gross margin), and national fleet, trade cars (which had a negative 1.7% gross margin), and wholesale cars do not really contribute to total gross profits. For Evans Hall, the gross per unit, when translated to U.S. dollars works out to a little more than $1,300 per unit, so not nearly as good as Stratstone (and likely why you see UAG and Group 1 focused on the luxury side of the market in the U.K).
For Asbury (NYSE:ABG), 28% of total gross profits in 2006 came from new vehicle sales, 15.3% came from used, 39% came from parts and service, and 18% came from F&I. And so when I take Asbury's 167,000 (plus) new and used vehicles they retailed in 2006, I come up with a gross per unit of only $2,200 (I rounded down a bit), no where near Stratstone's gross per unit.
For AutoNation (NYSE:AN), 26.5% of total gross profits in 2006 came from new vehicle sales, 13.4% came from used, 37.5% came from parts and service, and 22.5% came from F&I. For AutoNation, when I take their 600,000 (plus) new and used units retailed in 2006, I come up with a gross per vehicle of around $2,000. Clearly better than Evans Hall. But keep in mind 27.3% of AutoNation's new vehicle revenue mix was classified as import premium luxury (not even including luxury brands like Cadillac). So even AutoNation isn't a great "comparable" with high volume brands in the U.K, but hopefully helps put things in perspective a bit.
Administrative Operating Efficiencies
Ok, not something that I can directly compare to anyone in the U.S. (although AutoNation and Lithia (NYSE:LAD) have said they are working toward something similar), but Pendragon 425 people in their shared services center providing "a range of services" to around half of their dealerships including call centre and accounting. When you consider they have a total of 390 franchises in the U.K., nine locations in California, and five in Germany, I think it shows they can spread administrative costs over a pretty large base.
I'd love to talk about how they therefore have a better expense structure, but to be honest, I just don't think the way Pendragon reports allows us to draw a conclusion like that either way. Operating expenses as a % of gross profits at Pendragon were ~80% of gross. But they've got finance and insurance income below the operating expense line item. If I add that back to gross profits I come up with 78%. However, they've also got a commercial leasing business and even a DMS company in those results as well, so it just is not entirely comparable.
Pre-tax profit (return on sales)
Ah yes, the return on sale, or to a certain extent even your investment.
Pendragon's 2006 pre-tax profit margin was 1.9%, and pre-tax profits were up 51% (year over year). True there is a huge acquisition in there and share dilution. But even though this wasn't a very good year for Pendragon, earnings per share were still up 12% (year over year). And like I have said, over the last 5-years they have produced a compound annual growth in earnings per share of 26.4%.
Asbury had a pre-tax profit margin of 1.9% in 2006, and pre-tax profits were up 15.7%, and earnings per share from continuing operations were up 13.5%. And when you consider they earned $2.30 in 2002 (although admittedly you really have to decide what to include and exclude with that figure), I think we can pretty safely say Asbury has posted over 10% compound annual growth in earnings per share over the last five years.
AutoNation had a pre-tax profit margin of 2.9%, and pre-tax profits were down 13%. Now AutoNation also had some capital structure adjustments (borrowed more money to buy back shares). So earnings per share from continuing operations were only down around 2% (year over year). And similar to Asbury you've got some judgement issues about what to include/exclude in AutoNation's 2002 earnings per share figure (to assess the real operating earnings), if you take $1.16, you basically come up with a 5-year compound annual growth rate close to 5%.
So these are the 7 differences I can think of right now between the UK and the US market. I hope you found it helpful.