🐂 Investors are bullish on franchise dealerships. Here's why...
Plus... Why do dealers overpay for cars?
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Today’s topics:
🚗 Shoppers corner: why do dealers overpay for cars?
⚡ Lightning round: Santander postponed ABS sale. Now what?
🐂 Investors are bullish on franchise dealerships. Why are they in a better position to weather a recession?
Reading time: about 3 min
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🚗 Shoppers corner: why do dealers overpay for cars?
The latest data from Black Book says that the market reported the largest single-week wholesale values increase in quite a while last week. Dealers I talk to from all over the country are reporting similar patterns that I tweeted about last week. Auctions are on fire. Rental companies are overpaying on any clean car under 60K miles, fighting with CarMax and Carvana. Many used 2021-2022 cars are selling for more at auctions than at retail stores. Dealerships who dump their cars at Manheim end up selling them for $1,000-3,000 above market average.
At the same time, dealers struggle to make a profit on these units, because when overpaying at auctions, there’s potential for no margin in the deal from the get-go. Why do dealers overpay for cars then?
Because overpaying can be better than having nothing to sell.
Selling a car at a “front end” loss, (an industry term that means selling a vehicle at a loss), provides optionality and opportunities to make some profits on other parts of the transaction.
Trade-ins: A customer may bring a good quality trade-in that can be reconditioned and sold to another shopper. With tight supplies at auctions, trade-ins become an essential avenue for dealerships to replenish their inventory.
Referrals: A customer who’s happy with the purchase and the experience will refer other customers to the dealership.
Financing: Financing vehicles is another way for dealerships to make money on the “back end” (the industry term for profits made on value-added upsells). This is not always true because some financial institutions charge dealerships steep fees for financing risky customers. This could be a win or a loss.
Aftermarket products: A dealership can also offer aftermarket products, such as warranties, GAP insurance, exterior and interior protection, pre-paid maintenance contract, parts and accessories, and so on.
Service: Finally, smart dealerships are bringing customers back into their service lanes, where profit margins are traditionally high. Overall, dealerships operate on very slim margins, but the parts and service department sees margins of 40% - 50% or more.
In the end, it is better to have cars to sell. An empty lot is not a good signal to prospective shoppers (and is 100% unprofitable).
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⚡ Santander postpones ABS sale. Now what?
Santander has delayed selling $942 million worth of bonds backed by subprime auto loans due to market volatility.
Here’s why this is a big deal:
If banks cannot obtain liquidity for loans they wrote to consumers, they will inevitably continue to tighten their lending, as seen in 2008 with mortgage-backed securities.
Santander, along with other banks, has been tightening subprime lending due to concerns about risk exposure.
Source: S&P Research
However, in my previous newsletters (here and here), some subprime auto lenders have not been as disciplined as others, potentially putting bondholders at risk.
Santander's delay in selling their bonds is a major concern, indicating that other subprime vendors may face similar situations and subprime lending could dry up.
I'll keep a close eye on this and provide updates in my upcoming newsletters.
🐂 Investors are bullish on franchise dealerships. Why are they in a better position to weather a recession?
I had a good conversation with an analyst at one of the top investment firms. He told me that his company is bullish on franchised dealerships for the next couple of years. Coincidentally I just tweeted the same idea: franchised dealerships are better positioned to face what’s coming in 2023.
Franchise dealers will be fine due to lease returns and higher-quality trade-ins.
The image below is current used car supply:
— CarDealershipGuy (@GuyDealership)
Mar 13, 2023
Here’s more on this topic:
High interest rates: Auto retail is particularly sensitive to interest rates, given the need to carry inventories and consumer use of financing to purchase vehicles. One of the largest factors impacting projected profits for dealerships is the Fed’s aggressive tightening. Franchise dealers have access to better floor plan options backed by lines of credit established at low rates, well into the future. They benefit from a larger and more diverse pool of lenders and can easily handle a few more interest rate hikes without major headaches, as confirmed by the CEO of Asbury Group on the latest earnings call. Some franchised dealers can also benefit from low subsidized APRs offered by manufacturers.
Floor plan expenses: High interest rates affect another aspect of dealership operations: floor plan expenses. For some smaller dealers, floor plan interest expense has nearly doubled in the past year — a rising cost that creates a serious challenge for dealers who can’t dispose of their aging vehicles as fast as they should.
Inventory shortage: Let’s talk about inventory. While floor-planning hundreds of cars can get expensive, not being able to fill your lot is an even bigger problem. The demand for used vehicles has seen significant growth due to record-high new car prices. The shortage of new cars is causing fewer individuals to sell their used cars. New car production is still struggling to catch up to its normal levels, and now we have a structural shortage of used cars. This shortage will stay with us through 2023: the production in 2022 was at 14.7M units, while it was close to 17M in 2018.
Source: Wards Intelligence Report
Access to trade-ins & lease returns: Filling lots with quality cars has been a struggle and franchised dealers have an edge over used-only stores by having access to trade-ins and being ahead in the pecking order to acquire off-lease vehicles. Even though leasing has not been popular and many consumers keep their leased vehicles, 3-year-old lease returns are still very desirable units that command premium pricing.
OEM CPO programs: Franchised dealers are taking advantage of manufacturer support in marketing Certified Pre-Owned (CPO) programs, positioning CPO vehicles as an alternative to new ones while charging more for then non-CPO used vehicles. Certified pre-owned (CPO) sales in January rose 21.5%, nearly 36,000 units, over last January according to Cox. Some independent dealerships are also offering their own certification programs, but these programs don’t carry the clout of official OEM certifications that come with a variety of perks, such as roadside assistance, loaner vehicles, free maintenance and others.
Interestingly, faced with the shortage of late-model used cars to certify, some manufacturers are now relaxing certification requirements and are expanding their CPO programs to older vehicles, up to 9-10 years old!
Profit margins: Traditionally, used vehicles’ profit margins have been higher than new ones, however, due to inventory shortages dealerships can easily sell all their new-car allocations without any significant discounting. Some dealerships report that over 50% of their units are pre-sold even before arriving at their stores.
Indeed, the front-end gross profit on used cars has been great during the last few years. Compared with pre-pandemic years, the current front-end gross of around $1,800 per vehicle looks very decent. However, the average net retail profit per used vehicle is now below $900 and is trending down. The net profit is facing compression due to the inflationary economic environment when everything - from personnel to rent and other expenses - is going up. Paying more at wholesale auctions – still the primary source of inventory acquisition - also eats into the retail margin.
Diversification of revenue: As always, the natural diversification of dealers’ lines of business helps them shield profits from the industry’s variability. Franchised dealers rely on multiple revenue streams: new car sales, used car sales, service sales, parts sales, F&I, while used-only dealerships mostly rely on car sales and F&I only. Parts & service profit margin are typically much higher than both new and used vehicle departments, despite making up a lower percentage of revenue.
OEM rebates: Manufacturers are steadily normalizing production and are increasing rebates and incentive programs as new car inventories start to build up. Rebates play in the hands of franchise dealers as they help with boosting sales. On the flip side, the introduction of rebates will hurt the values of late-model used vehicles - their values will decline.
OEM support for new tech: Above all, we see early signs of shifts from classic to emerging profit pools. Growing EV sales bring new challenges for dealerships in the areas of charging, servicing, training personnel, investment in new F&I and customer interaction tech. Franchise dealerships have an upper hand here with manufacturers’ support and more cash reserves to invest in modernizing their stores, updated software, and training their personnel.
Source: Forbes
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