Greenfield's Point of View - November 2021

The COVID Premium in Automotive Technology

It’s been an interesting year.

At the beginning of the pandemic, companies were suffering through a “COVID Discount”, due to the retraction of the economy, uncertainty of how the rest of the year was going to pay out, and how hard a reduction in consumer demand was going to affect revenue and earnings.

Fast-forward eight months, and we’re experiencing a “COVID Premium”, fueled by a resilient U.S. consumer, companies that made dramatic cost cuts, a buoyant stock market, a love affair for SaaS companies, over a billion dollars of “dry powder” looking for a home, and a sense of urgency to get deals done. There’s a shortage of good deals out there, and a lot of money chasing it. This is causing strong valuation premiums.

But, before we look at M&A, let’s take a look at the economy.

The Economy

This recession was by far the deepest one in postwar history, but it also may go into the record books as the briefest in U.S. history.

A two-track recovery is emerging. Some workers, companies and regions show signs of coming out fine or even stronger. The rest are mired in a deep decline with an uncertain path ahead. Just months ago, economists were predicting a V-shaped recovery—a rapid rebound from a steep fall—or a U-shaped path—a prolonged downturn before healing began. What has developed is more like a K. On the upper arm of the K are well-educated and well-off people, businesses tied to the digital economy or supplying domestic necessities, and regions such as tech-forward Western cities. By and large, they are prospering. On the bottom arm are lower-wage workers with fewer credentials, old-line businesses and regions tied to tourism and public gatherings. They can expect to bear years-long scars from the crisis.

This divergence helps explain the striking disconnect of a stock market and household wealth near record highs, while lines stretch at food banks and applications for jobless benefits continue to grow.

The labor market isn’t expected to claw back all of the jobs lost as a result of coronavirus-related shutdowns until 2023 or later. Hiring gains slowed sharply heading into the fall as more layoffs turned permanent, adding to signs that the economy faces a long slog to fully recover from the coronavirus pandemic.

The economy has lost millions of jobs this year. But in many industries, hiring is booming. Home-mortgage firms, financial-service companies and tech companies are advertising thousands of jobs. Others, in sectors like hospitality, fall victim to continued lockdowns and changing consumer behavior.

The economy grew at a record pace in the third quarter, recovering significant ground lost earlier in the coronavirus pandemic. Gross domestic product—the value of all goods and services produced across the economy—increased at a 33.1% annual rate, by far the strongest quarterly pace of growth in records tracing back to 1947. That is decidedly good news, showing a faster-than-expected rebound as businesses reopened and consumers grew more confident about venturing out and spending money.

But growth slowed throughout the quarter. Monthly data show that in August and September activity slowed sharply, though it didn’t contract, while daily and weekly data suggest a small advance in October.

The big question now is whether growth will continue to advance with COVID-19 cases soaring once again. That will depend crucially on what steps states take, if any, to restrict business activity in response to those rising cases. Forecasters expect the economy to expand through the fourth quarter, though more slowly. Analysts project the economy will end 2020 smaller than a year earlier, but will grow in 2021.

Finally, it’s worth noting that there may be long-term damage to the economy. The Congressional Budget Office (CBO) in September forecast fairly steady GDP growth once we get past 2020, but output isn't expected to catch up to its pre-pandemic trajectory anytime soon. Although the economic effects of the pandemic will continue to be felt as far out as three years from now. According to the July’s CBO’s economic outlook report, the unemployment rate will not return to pre-COVID levels for at least a decade and the recent Federal Reserve projections in September show unemployment above 4% for the foreseeable future.

Housing

The housing market is booming, but serious challenges are looming for low-income owners. Expect a wave of foreclosures in 2021. As of August, more than 10% of the eight million single-family mortgages backed by the FHA were delinquent by more than three months. Forbearance provisions, preventing foreclosures, expire next year.

A housing crisis centered on the vast apartment and home-rental markets is emerging in the U.S., threatening to send millions of renters into eviction and leave landlords short billions of dollars. A large number of renters have been unable to pay some or even all of their rent since March, when the pandemic temporarily shut down businesses and pushed millions of people into unemployment. Federal and local eviction moratoriums have protected many from losing their homes but the national eviction ban and some state and city protections are set to expire by January or sooner, the fallout from missed rent payments is bound to imperil a large swath of the U.S. population and wash over the broader economy.

Automotive

It’s a good time to be an auto dealer. Despite (or maybe because of) the Covid pandemic, dealers are more profitable than ever.

Q3 earnings calls have shown that dealers are recording record quarterly profits, largely due to reduced employee, operating and marketing costs, coupled with strong new car and used car gross profit per unit. AutoNation, Penske Automotive Group and Lithia Motors all reported record results with bottom-line increases topping 80 percent.

The key question is whether dealers will be able to keep operating lean as the economy rebounds, as they may be tempted to add back operating costs.

Buy/Sell activity for physical dealerships and valuations remains very strong, and there’s a heathy backlog of deals that will take us into mid-2021. Demand for physical dealerships is being fed both by dealer groups who continue to consolidate, as well as Private Equity, who seems to have a renewed interest in the space. On the sell-side, many owners are looking to sell into a strong market, continued strong valuations, and all the uncertainty of how the next decade will play out.

New-vehicle inventories tightened further in September to just 2.11 million vehicles, a decline of about 150,000 vehicles from the previous month, the lowest industry inventory level in nine years -- and more than 1 million fewer new vehicles available for sale than at the same point a year earlier.

Five months after vehicle production restarted for many of the OEMs, car dealers are still seeing their stockpiles dwindle as public transit-averse buyers flock to the new-car lot and more people relocate to the suburbs. Some executives say it won’t be until early next year before stock levels return to normal.

Despite the strong third quarter performance for dealerships, there are warning signs on the horizon that the fourth quarter is going to be a bit more challenging.

Black Book reported that wholesale prices steadily declined through October, marking seven weeks in a row. Wholesale sold volume rebounded in October but is still lower that it was in 2019. We’re starting to see an influx of used inventory coming into the auctions – an increase that is expected to last into the first half of 2021, resulting from prolonged lease return delays. In addition, lenders restarted repossessing vehicles, as the economy continues to feel the effects of high unemployment. With much weaker retail demand, and a projected oversupply of used inventory, Black Book forecasts a significant drop in wholesale prices this fall and winter.

M&A

Hampleton Partners reported that Global automotive technology M&A activity was down by 11% in the first half of 2020, compared to the second half of 2019. But, while deal flow has been light during the first few months of the pandemic, the resilience of the automotive industry through COVID-19 has given more confidence to both financial investors and strategic acquirers. As a result, the M&A space is really heating up.

VC firms have continued to be very active throughout the pandemic. Deal counts and deal values are stable to up over last year. The massive expansion of later-stage private capital continues unabated. Valuations continue to rise. And exits have been very robust.

U.S. VC funding in Q3 was the second highest quarter ever at $36.5b dollars being invested, up 22% year-over-year (YoY) and 30% from Q2 2020.

The rate of US private equity deal making in 2020 continues to lag well behind past years. But the market is beginning to bounce back after bottoming out during the second quarter.

September was the busiest month for IPOs in the New York Stock Exchange’s history, and October was on track to also break a record. 2020 is very likely to turn out to be the biggest year for IPOs since 2014. We’ve seen 169 companies taken public via SPACs in 2020, up from just 59 in 2019, raising 460% more in gross proceeds than last year.

Valuations

Software has been hot. SaaS Capital reports that public company Software-as-a-Service revenue multiples continue to skyrocket, recently reaching 15-times average revenue run rate, the highest that we’ve ever seen for software valuations. Investors clearly love the SaaS model.

Online Retailers

Online automotive retailers continue to attract capital. Carvana’s market cap of $37 billion is definitely increasing investor interest in the automotive category.

Shift Technologies became a public company this month (through a SPAC), but the stock hasn’t move much since.

UK online retailer Cazoo just launched 11 months ago, and has a business model similar to Carvana’s. After a financing round last month, the company is now valued at $2.5 billion dollars.

A lot of investor interest has been fueled by consumers shifting their shopping preferences due to COVID-19. I’m certain that we’re going to see a number of other online dealership players emerge, given the frothiness in this market.

Blurring of Lines Between Physical, Online and Wholesale

We’re definitely witnessing a blurring between physical dealerships and online models, both consumer-facing and wholesale. This convergence will continue, fueled by strong valuations of companies like Carvana.

Last month we saw an interesting big deal from LMP Automotive Holdings, the e-commerce and facilities-based platform for consumers who desire to buy, sell, subscribe-for or finance used and new vehicles. LMP announced the acquisition of a 70% Interest in New York’s largest franchise dealership group, Atlantic Automotive Group, and New York logistics and vehicle storage company, Atlantic Central Storage, in a deal valued at $608 million dollars.

When technology companies start acquiring physical dealerships, you really need to start scratching your head. We’re definitely in interesting times.

Also last month, BCA Marketplace, the largest physical auction company in Europe launched Cinch, an online marketplace for consumers. BCA already owns We Buy Any Car -- that acquires vehicles directly from consumers.

BCA Marketplace was a public company until it was bought by private equity giant TDR Capital for £1.9 billion British pounds in September of last year.

It’s interesting to see a wholesale auction company that also buys vehicles directly from consumers, and now offers vehicles to consumers to purchase.

We’ll be keeping a watchful eye on how dealers specifically react to this as it plays out in the UK. In the U.S. market, dealers might push back on such a move.

Here in the U.S., the largest retailer of used vehicles -- CarMax -- runs the third largest auction company in the country, with over 70 locations. CarMax sells over 400 thousand wholesale vehicles per year. And remember that CarMax made a $50 million dollar investment in online shopping site Edmunds early this year, which raised a lot of eyebrows.

Carvana recently launched their wholesale channel, CarvanaACCESS, powered by Manheim’s OVE. Like CarMax, Carvana needs an efficient way to dispose of trade-ins and aged inventory they don’t need.

Rumor is that ACV Auctions, which has been aggressively taking market share from Manheim and ADESA – and who has a lot of momentum due to strong revenue growth – will IPO sometime in early 2021. It will be interesting to see if they make any big M&A moves prior to becoming public.

Last month, it was announced that CarLotz, an online consignment store for used cars, will go public via a SPAC. A group of investors that includes KAR Global has also committed to a $125 million investment into the company. It’s VERY interesting to see KAR Global, the parent company of the second largest physical auction company ADESA, invest in a physical dealership.

DMS Space

Tekion Corporation, a cloud technology company and provider of a software-as-a-service DMS they call their “Automotive Retail Cloud”, announced its Series C financing round of $150 million dollars at over a $1 billion dollar valuation. The funding round was led by global Private Equity firm Advent International.

Tekion has big ambitions in the DMS space that has long been dominated by CDK Global and Reynolds and Reynolds.

Tekion claims to already have 17 OEM integrations completed, and expects to have the others done by early 2021.

Tekion hopes to solve the issue of technology fragmentation that has plagued the industry for decades. With its modern cloud-based platform -- complete with a centralized accounting system built on a secure data platform -- Tekion says dealers can access their company’s data from anywhere -- while also providing seamless access to vendors via its set of APIs.

Tekion will definitely be a company to watch, as it attacks the two largest software providers in the DMS space.

NADA Going Virtual

Finally, sad news for the industry as the National Automobile Dealers Association opted to make its annual convention completely virtual and move it to Feb. 9th through 11th — a rare Tuesday to Thursday schedule. NADA is always a great venue for dealers to discover new and innovative technology companies, and for a ton of M&A deals to get announced. It’ll be sad to miss seeing all of this in person this year, but I’m certain they’ll put on a strong virtual event.

A Final Word

I publish this newsletter at an interesting time – just two days from the November 3rd presidential election. While the M&A pipeline has been heating up, there’s fear of possible increasing tax rates, a strong and resilient stock market, and strategic acquirers wanting to take advantage of COVID weakness.

As I’ve said all year long -- It’s an exciting time to be in the automotive space.