Writing about finance in the collision repair industry, naturally we speak quite a lot about business valuation and maximizing the value of your business. Buying or selling businesses are currently very prevalent activities in the industry. In financial terms, buying is often called an “acquisition” while selling your business may be referred to as a “liquidity event”.
There is a lot of industry chatter around these events. It seems that every week there is a new breaking story where one of the large consolidators acquires another group of repair facilities. By the end of 2015 it is a near certainty that at least one if not two companies will reach $1 billion in revenues with even more growth coming.
I often focus on the tactical, i.e. how to best position yourself to buy, sell or hold. But it is also important to take a step back from time to time to look at the overall picture. What is driving this change in the industry? Often we hear that the increasing technological complexity of repairing a vehicle drives consolidation. We also hear a lot about the benefits of scale, or how having a large nationwide footprint results in a competitive advantage in the result of increased revenue opportunities, a decreased cost structure, or perhaps improved operations. These are all valid reasons for growth but not necessarily the primary drivers of consolidation.
Rather, there are two financial forces that work in unison driving consolidation and not just in the collision industry (Editor’s Note: Keep an eye out for an upcoming article on how these forces are driving consolidation in other areas of the automotive industry like paint and dealerships). The first factor driving investment and consolidation in the industry is the cost of capital, or more simplistically, low interest rates (Editor’s Note: We will also dive deeper into explaining how the cost of capital works and why it is critically important when evaluating certain contracts in your business such as paint prebates). In general, when the cost of capital is low, traditionally lower return higher risk projects are more attractive to large investment groups.
The reason for this is due to the way large investment groups evaluate an investment. When determining if an investment is worthwhile, an analyst will essentially evaluate two factors against each other – the risk adjusted rate of return on the proposed investment versus the cost of capital required to make the investment. The difference, or spread, between the return and cost is the percent the firm will net from the investment.
When the cost of capital is low investments that are relatively less profitable are much more attractive because the cost of obtaining the necessary investment dollars is much lower as well. Put another way, it is not that the collision industry suddenly became more profitable. Rather the cost of investing in the collision industry has dropped substantially.
While the low cost of capital makes the collision industry relatively more attractive than it would be in a normal rate environment, the theory of “multiple arbitrage” in conjunction with low rates really drives investment in the industry. Multiple arbitrage can be thought of the idea that the whole is worth much more than the sum of the parts.
Practically speaking, in the collision industry a group of 10 shops selling as one business is worth more than 10 individual shops for sale. Where an individual shop may sell for 2 or 3 times EBITDA, a 10 location business may sell for 5 or 6 times EBITDA. On a relative basis, the 10 shop small MSO is worth nearly twice as much as the single shop business. (You can get a refresher on EBITDA here, and an example of multiple arbitrage here and here).
The numbers continue to increase as scale is built. It is estimated that Caliber recently recapitalized at 18 times EBITDA. I’ve been informed that a public IPO of any of the large collision repair groups may go to market as much as 21 times. These numbers are all hearsay and guestimates, but they illustrate the larger point – the larger and more disperse the business, the more value that is created.
As mentioned above size is indeed valuable. But size and scale is the result of investments attempting to take advantage of multiple arbitrage, rather than the driving force behind investment. Size and scale for the sake of size and scale does not create value. More likely, the need to achieve “critical mass” plays more of a role in driving value. In business school, critical mass was defined as the point where a company becomes financially independently viable without having to add additional investment. That is not to say that more investment is not necessary or prudent for competitive reasons, rather that the company is able to operate on a national scale without investing in additional call centers, equipment, real estate, etc.
Consolidation is a trend that will continue to shape the collision industry. The need for players with a nationwide footprint that are well capitalized and able to invest in the future is indisputable. The growth of companies that can deliver on a nationwide standpoint is a result, rather than the cause of investment in the industry. But what makes the collision repair industry so attractive from an investment standpoint is the ability to drive incredible investment returns as a result of multiple arbitrage and a low cost of capital.
Knowing how the large investment groups view the industry, what does this mean for your business? I would very much like to hear from you what your strategy is: buy, sell, or stand pat?
As always, if you would like to discuss the strategies available to you in more depth please feel free to send me a note on my contact page. I find all of this fascinating. All communication is kept extremely confidential.
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Until next week.