Defining 'Blue Sky'
By Sheldon Sandler
What exactly does Blue Sky mean? No, for readers of Dealer magazine it's not the light purple hue of the earth's atmosphere. In the idiom of the automotive industry, "blue" is the intangible value of a vehicle dealership above its hard assets. It equals earnings multiplied by a benchmark number, which ranges from one to six or more.
That all-important multiplier is determined by a seemingly mystical algorithm which takes into account the strategic importance of the dealership, its products, stability of performance, location and level of competition, to mention just a few subjective factors. Expected investment payback and the market multiples generally obtained for particular brands establish parameters. For example, certain high lines like Mercedes Benz and Lexus, as well as Honda and Toyota, generally receive higher multiples than Daewoo or Lotus.
It's common to hear comments like, "Harry got four times blue for his Chevy dealership." The critical question, though, is four times what? Or more precisely, what earnings should be used in the calculation? Conventionally, historical profits have been used. The favored approach is to average three to five previous years' adjusted earnings as found on dealer statements. That might make some sense in the case of slow-growing, less prominent dealerships. Undoubtedly, buyers, particularly the private kind, prefer to look through the rearview mirror because they are more concerned with proven stability than prospects for growth. Their first concern is the safety of their investment. The problem is that in the case of quickly growing, strategically situated or exceptionally operated dealerships, the traditional formula does not properly account for future earnings power.
Fast growing dealerships with hot products in developing markets merit a more forward-looking, realistic formula. In these cases, earnings should be a blend of the prior year's and projected current year's pro forma earnings. A good case in point would be valuing an Acura dealership now. Looking back at Acura over the prior four or five years, it was a truly troubled franchise. Dealers had to be selling another brand or be a good used operation to make any money. Now, with a solid 1999 enjoyed by most, renewed commitment by Honda and the introduction of numerous new products, the future looks rosy. It would not be rational to value these dealerships off of the past five years' results.
The next question is what is meant by adjusted earnings? They are reported "pro forma" earnings recalculated by adding back certain non-recurring expenses. They include those expenses, which are either non-recurring or will cease to exist under new ownership. For example, most owners' compensation would be "add backs." So would litigation expenses incurred for the recovery of insurance benefits for the fire loss of a show room. Likewise, to be consistent, non-recurring gains would count against stated earnings. For example, had the proceeds from those insurance proceeds been included in income, a deduction would be in order.
It has been our observation that the most prominent dealers have succeeded by taking risk. They evaluate the value of a dealership under acquisition consideration not so much by past performance but by the future under their stewardship. That sometimes leads to expensive valuations, but often leads to big payoffs. At the end of the day, it's the clear view through the windshield that will avoid missed opportunities.
Sheldon Sandler is CEO and a founding partner of Bel Air Partners. Bel Air advises its clients on capital market transactions including Initial Public Offerings, REITs, franchise loans, private placements, and mergers and acquisitions. ssandler@dealeronline.com
