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Greenfield's Point of View - October 2020

A Mad Rush of M&A Before The End of the Year?

It looks like we may experience a bunch of acquisition activity between now and the end of the year. Which will keep things interesting.

But first, let’s look at the economy.

The Dow Jones Industrial Average crested 29,000 in early September, for the first time since February. The S&P 500 and Nasdaq Composite both reached new records. Stocks have soared from their March lows with help from the Federal Reserve, which cut interest rates and moved to stabilize financial markets, and on hopes for a vaccine or treatment for the coronavirus.

We really are living through a tale of two economies. The coronavirus recession has been financially devastating for many Americans, but has been a boon for others. Those with secure jobs, stuck at home with fewer places to spend money, came out ahead. The stock market, predominantly owned by the wealthiest Americans, has returned to record levels. For others, the federal government rushed in with additional unemployment benefits, stimulus checks and a moratorium on evictions and foreclosures. But the ranks of the struggling are growing. The $600 in additional weekly unemployment benefits expired in July. People have largely spent the stimulus checks they received in the spring. Lenders are bracing for more people to fall behind on debt payments. Almost 11% of U.S. households didn’t have enough to eat in the previous seven days, as of July. That number was about 4% back in 2018.

On the Upside

The U.S. economy is recovering from the coronavirus-related downturn more quickly than previously expected. Business and academic economists expect gross domestic product to increase at an annualized rate of 23.9% in the third quarter. However, a rebound in the third and fourth quarters isn’t expected to make up for ground lost earlier in the year—projected growth in the third quarter would recoup about half of the output lost in the first half of the year. To return to the previous peak recorded in the final quarter of last year, the economy would need to grow at a roughly 24% rate again in the fourth quarter of this year. Economists see that as unlikely.

A resurgent stock market and fiscal stimulus propelled the net worth of U.S. households to the highest level ever in the second quarter.

Consumers are growing more optimistic about the state of the U.S. economy, as the labor market continued to gradually improve and a summer coronavirus surge receded in parts of the country. Consumer confidence posted its biggest increase since April 2003.

One positive outcome from the pandemic, and the resulting financial downturn, is that Americans are starting new businesses at the fastest rate in more than a decade. Applications for employer identification numbers (that entrepreneurs need to start a business) have passed 3.2 million so far this year, compared with 2.7 million at the same point in 2019.

Historically, financial recessions been a good time to launch businesses. Many of today's best-known companies were founded during the Great Recession in 2009, including Uber, Groupon, Venmo and Airbnb.

I’ve been speaking recently with a number of new automotive tech startups who are taking the opportunity to launch new companies during COVID -- many of these being started by industry executives who are either unemployed or underemployed. I have a strong feeling that we will see a slew of new innovative automotive tech startups emerge from this challenging economic period.

Now for the Downside

U.S. debt has reached its highest level compared to the size of the economy since World War II and is projected to exceed it next year, the result of a giant fiscal response to the coronavirus pandemic. The Congressional Budget Office (CBO) said that federal debt held by the public is projected to reach or exceed 100% of U.S. gross domestic product in the fiscal year that begins on Oct. 1. That would put the U.S. in the company of a handful of nations with debt loads that exceed their economies, including Japan, Italy and Greece.

Longer term, the U.S. economy is likely to grow more slowly in coming decades and the public debt burden will increase more than previously forecast, due in large part to the coronavirus-induced recession. The CBO anticipates average annual GDP growth of 1.6% from 2020 to 2050, roughly a full quarter percentage point less than it expected in June 2019, the last time it released long-term economic projections. Growth averaged 2.5% from 1990 to 2019. Debt as a share of gross domestic product is forecast to hit 195% by 2050, 45 percentage points higher than the CBO projected in June 2019.

The Federal Reserve pledged to support the economic recovery by setting a higher bar to raise interest rates and by signaling it expected to hold rates near zero for at least three more years. It stepped up calls for additional government spending to avoid an uneven and protracted economic recovery from the coronavirus pandemic.

Laid-off workers are cutting spending and searching for jobs as extra unemployment benefits run out. Millions of unemployed Americans had covered expenses with $600-a-week in extra unemployment benefits provided by the federal government. Now those benefits have expired and been replaced by a short-term extension at half the rate—and many workers are still waiting for the additional $300 payments to arrive. Although the benefit reduction hasn’t triggered broad cutbacks in spending across the economy, data show spending by unemployment beneficiaries has weakened. Economists expect the benefit reduction to dent consumer spending in the coming months.

About one million homeowners have fallen through the safety net Congress set up early in the coronavirus pandemic to protect borrowers from losing their homes, potentially leaving them vulnerable to foreclosure and eviction. Homeowners with federally guaranteed mortgages can skip monthly payments for up to a year without penalty and make them up later. They must call their mortgage company to ask for the relief, known as forbearance, though they aren’t required to prove hardship. Many people have instead fallen behind on their payments, digging themselves into a deepening financial hole through accumulated missed payments and late fees. They could be at risk of losing their homes once national and local restrictions on evictions and foreclosures expire as early as January,

Retail store closings in the U.S. reached a record in the first half of 2020 and the year is on pace for record bankruptcies and liquidations as the COVID-19 pandemic accelerates industry change.

The IPO Backlog is Growing

There’s a massive backlog of private high-quality companies that have been waiting for a market window -- and there’s a sense that the getting is good right now and many don’t want to miss this opportunity. With the uncertainty of the election, the backlog of unemployment that will have to play its way through the economy, and the continuing global health pandemic, there’s anxiety about what 2021 is going to bring. Many of these companies over thought it and waited too long and probably should’ve been public months ago and are now trying to get out while there’s still some stability in the market.

As a result, we’re seeing the biggest tech IPO streak in years. In fact, 2020 should be the biggest year for IPOs since 2014, when Alibaba went public.

How the coming IPOs perform will be a big test of the stability and strength of the U.S. stock market as we head into the final quarter of what’s been a very weird year.

The Auto Industry

The auto market has continued to perform strongly through the downturn. But September brought warning signs that we’re entering a softer fall. Wholesale auction demand and prices came back down from atmospheric highs. Dealer inventories of new and used cars are coming back into balance. And with the challenges to consumers mentioned above, we may see a softening of demand at the retail level.

New vehicle retail sales in September were poised to post the first year-over-year gain since February. Franchised dealers also continued to post significant growth in margins on new-vehicle sales. Total grosses per unit in September, inclusive of finance and insurance, are on pace to reach $2,189, an increase of $723 from a year ago.

The National Automobile Dealers Association (NADA) Dealership Financial Profile data for July 2020 showed that while total sales year-over-year were down almost 14%, Operating Profit was actually up 16%, thanks to a combination of expense reduction and having more discipline around holding vehicle gross profit per unit.

Dealers are recording record quarterly profits, largely due to reduced cost structures in the dealership due to COVID (employee, operating and marketing costs) coupled with strong new car and used car gross profit per unit. The key question is whether dealers will be able to keep operating lean as economy rebounds, as they may be tempted to add back operating costs.

Physical dealership buy/sell activity in the first half of 2020 surpassed the first half of 2019, despite the economic challenges of the recession. Buyers became increasingly aggressive as the second quarter progressed, fueled by strong cash flows from existing operations and low-cost acquisition financing in a declining interest rate environment. Sellers also grew more confident in their valuation expectations as earnings surpassed pre-COVID levels.

The resilience of the auto retail business model despite COVID, attracted more investors to the industry in the second quarter. These investors, including family offices and high net worth individuals, are actively seeking dealership acquisitions and the opportunity to finance industry consolidation. Many believe scale and innovation will increase future industry profits, fueling consolidation strategy theses.

In general, larger dealership groups are able to more easily reduce operating expenses and SG&A (sales, general and administrative expenses), as evident in the public groups’ strong recent performance. Also, larger groups often invest in proprietary selling systems and operating models which result in higher margins.

The high level of buy/sell activity in the second quarter supports an ongoing strong 2020 physical dealership buy/sell market and one that may surpass 2015’s peak level.

Online Retailing

As I speak with more dealers, I am starting to wonder how we’re best to define an online sale? I’m not finding many “Digital Retailing” deals arriving at dealerships not needing to be reworked. Speaking to the wholesale digital platforms, more than a third of their transactions have to be worked and ultimately consummated through humans on a trade desk. And even Carvana’s process seems to involve a good number of their advocates via phone or chat.

But this will all be a discussion for a future newsletter.

CarMax reported record revenue and profits for their second quarter, which ended on August 31st. CarMax completed its “Omni-Channel” rollout to its 220 stores, aiming to give customers a personalized and seamless buying experience whether they are shopping online with the device of their choice or visiting a store. CarMax’s Omni-Channel experience enables their consumers to seamlessly do as much, or as little -- online and in-person -- as they want.

Alternative delivery methods — curbside pickup or home delivery — rose slightly in CarMax's first quarter, but remained less than 10 percent of all sales. The company said its research found that customers don't want to be forced to interact 100 percent in-store or 100 percent online.

So far, CarMax’s progress on their Omni-Channel efforts hasn’t taken any wind out of the sales of Carvana and Vroom, which are trading very close to their all-time highs.

We eagerly await online Retailer Shift Technologies’ public listing. The Special Purpose Acquisition Corporation, or SPAC, that is acquiring Shift Technologies to take the company public, has called for a special meeting on October 13th -- where shareholders will vote to approve the business combination with Shift.

Expect that Shift will be publicly listed shortly after October 13th. We’ll be watching that IPO and the company’s market cap very closely.

A Final Word

Word on the street is that the M&A pipeline is heating up. Fear of possible increasing tax rates, the strong stock market, uncertainty around the Presidential election and strategic acquirers wanting to take advantage of COVID weakness -- could mean that we see a bunch of companies “crashing the gates” between now and the end of the year -- to either rush to become public, or get their companies sold.

KAR Global announced a $425 million deal to acquire BackLot cars to fortify TradeRev’s position as the number two online wholesale marketplace after ACV Auctions (who is rumored to be looking at a Q1 2021 IPO).

CDK Global has announced they are looking to sell their international operations. With revenue of $321 million and an expected revenue multiple of 3x to 4x, the division could fetch CDK $1.3 billion. It’ll be interesting to see who the potential buyers are.

It’s an exciting time to be in the automotive space.

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