Slowing Down

With US dealership inventories at 88 days on February 1st – 60 days is healthy – we are seeing a possible mismatch of sales relative to production. Yes, there's been bad weather across much of the US, and that kept shoppers away. This past week, though, I visited a half-dozen dealers while car shopping and used that as an opportunity to listen to them. What I heard suggests this is not a temporary blip.

...deals are on the way: if I could put off buying a car, I would...

First, the factory is hiking dealers' sales targets, and getting pushback: late 2013 is as good as it's going to get, and no, we aren't likely to do better. Of course every dealer wants a lower target, and they rightly fear the "ratchet effect" of overperforming leading to higher targets, even if their success was a result of idiosyncratic factors, such as hiccups at a local competitor or a sales blitz that worked in volume terms but not in profitability so won't be repeated. Still, my reading is that dealers aren't seeing the same sort of foot traffic, and they don't think it's just the weather. Furthermore, that is consistent with other macroeconomic indicators such as wage growth, interest rates and housing. Growth is anemic.

Second, supply is up both because new capacity is coming onstream (Honda and Mazda in Mexico, for example) or is available because of the weak yen (Toyota is again making money on exports from Japan, and has a lot of capacity there relative to the current size of the domestic Japanese market, which is also facing a big hike in sales taxes). That's bad news if there's in fact a slowdown, or at least not an increase, in sales. Oh, and neither Honda nor Toyota has seen any uptick in their market share this past year.

...[other indicators likewise show] growth is anemic...

Then there are new models, with incentives to make way for the old. As a result a quick scan of Automotive News headlines suggests a number of OEMs in that position. That's an argument for part of this rise in inventories reflecting model changeovers, but that will vary from firm to firm and ought to ease quickly.

Overall, though, my sense is that firms will have to either trim their production plans, and soon, or really beef up the inventories. And if we start seeing more vehicles coming off-lease and out of fleets, then tradein values will make moving the metal a bit more difficult.

So deals are on the way: if I could put off buying a car, I would. Now in my own case I can't, and what I'm seeing suggests I'll opt for a new vehicle over a used one. Yes, if I wanted to spend $23K there are many attractive larger cars out there, lots of BMWs and Volvos and the like at Carmax. But all I need is a car to get me to and from work, and my wife has nixed a relatively inexpensive Porsche Boxster that would do the trick, or even a coupe: with a 2-week-old granddaughter a couple miles away the ruling decree is that I need the option of putting in a car seat...

The Decline of the Japanese Auto Industry

Here are three graphs, pulled from a talk I gave at UMTRI in the spring. The Japanese auto industry – that is, manufacturing and retail inside Japan – faces permanent decline.

Two trends interact. First, due to demographics Japan's population is in decline, and so is the number of licensed drivers. I don't have statistics on the latter, but I have used Census data and population projections to calculate the potential number of licensed drivers. (In Japan you can't get a license as young as in the US, and after age 70 it becomes increasingly hard to get your license renewed.)

Second, the vehicle mix is unfavorable. From the production standpoint, exports are important, but the data show that the market isn't increasing, has more low-value vehicles and is very volatile. The third graph is the domestic parc, which is what matters for dealers. Here the story is even worse, while full-sized cars rose in share along with incomes, that process has ended. Instead what we see is a decline in mid-size car sales (compacts in the US context) and their replacement by "kei" minicars.

Here are implications, as I see them.

1. Over time dealers will face extraordinary pressure. That will be accentuated by the geographic aspect of population decline, because population will fall more and age faster in rural areas where car ownership is highest. Rural areas are already distinctly older than the major urban areas (Tokyo-Yokohama-Kawasaki-Chiba, Osaka-Kyoto-Kobe, Nagoya, Hiroshima, Fukuoka-Kita Kyushu, and Sapporo). Their potential market is literally dying off. Dealerships in Japan are also unable to sell across prefectural boundaries, so better-run dealerships can't use the internet to extend their geographic market to offset local decline.
2. Manufacturers will face a smaller market. They have a large number of distribution channels – not including trucks, Toyota has six channels: Daihatsu, Netz, Corolla, Toyopet, Toyota and Lexus, with lineups that overlap and cannibalize each other. (Dealerships are also multi-point, with sales points each trying to buy business from other parts of the same dealership, while the strong players in used cars are independents such as Gulliver.) Rationalizing production and model mix and distribution will be traumatic, as we've seen with the efforts of GM, Ford and Chrysler in dropping multiple brands.
3. Suppliers will have an even harder time. Small Japanese suppliers were slow to internationalize. Even worse, when I've visited suppliers in Japan for engineering presentations – and in sharp contrast to similar visits in the US and France – I've been the only non-Japanese in the room. That hurts in two ways.
   • First, there just aren't that many would-be engineers graduating from Japanese universities. Without international staff they simply won't be able to stay in the game. Honda and Toyota have huge engineering operations in the US that can handle the entire vehicle development process. As far as I can tell, that's not the case with most Japanese-headquartered suppliers.
   • Second, in order to serve their customers on a global basis, suppliers need to have the same global capability. Some will finesse that by being acquired by foreign firms, and thereby globalize their engineering. Others will prove unable to build a global engineering and manufacturing presence because they've been slow to delegate decision-making and build capabilities and staffing outside Japan. They will steadily lose market share to firms with HQs outside Japan. Indeed, my scanning of industry news (in English, Japanese and [less frequently] German) supports that. Toyota is turning more and more to the big US/Europe based global suppliers, because their own "keiretsu" suppliers can't support Toyota's global footprint.
   • Now this is a third bullet, but is speculative so I won't claim it as a 3rd point. My belief is that because of the two factors above Japanese suppliers lag in technology. Casual empiricism turns to the body of finalists in the Automotive News PACE competition, who are chosen on the basis of successful innovation. Japanese firms are largely absent. [Mea culpa: the competition is entering its 20th year, and I've been a judge since the start.] Not having a truly global mindset, not having the bulk of engineers in Japan able to use English as a working language, means that Japanese suppliers are behind the eight ball in technology. Sometimes it's better to be a bit behind where you can learn from other's mistakes and simply not invest spend money on "advanced concept" R&D that leads to dead ends, the "bleading edge" thing. OEMs also want second sources, so even firms that have reasonable intellectual property know they won't have a monopoly. Still, my judgement is that being second source is less profitable. And being second-source based on production in Japan is a losing proposition.
4. Japan, as a geographic entity, is already a shrinking part of the global industry. Of course the growth of the BRICs and ASEAN means the same is true of the Euro zone and of NAFTA. My belief is that slow internationalization will accentuate the impact of a shrinking domestic market. That's particularly good new for non-"Japan" suppliers.

In the 1980s the US industry feared that domestic firms would disappear under the onslaught of Japanese "keiretsu" suppliers. That's not what we see if we look at the top 100 suppliers today.

Tesla's Distribution Challenge

...the issue isn't whether Tesla's distribution approach is legal, it's whether it's sensible...

Tesla is distributing its battery electric cars directly, rather than through franchised dealers. That's raised a hulabaloo from NADA and dealers about legality. Texas is one large market in which Tesla may be stymied for several years; its attempt to get legislation that would permit direct sales is dead this legislative season, and the next session isn't for two years, until 2015. Barring judicial support, that's a long wait in a large market. There may be room to do so, since the firm has no franchised dealers in any state, hence the idea that it is undermining dealers protected by franchise agreements has no merit. Be that as it may, taking the issue to the courts takes time, and Tesla would like to become a volume manufacturer sooner rather than much later. Time will tell, but time is not in their favor.

The real issue, however, isn't whether Tesla's distribution approach is legal, it's whether it's sensible. In his visit to Lexington to speak to my Economics 244 students, David Ruggles posited that it's ultimately unworkable. Let me make a few points in that direction; interested readers might find the Dicke chapter cited below of interest, and hopefully David will add his thoughts.

1. 1. For a firm seeking to expand, dealerships are the cheapest available source of finance. We can ignore the up-front fees to purchase franchise rights (at issue in the failed attempt of Mahindra & Mahindra – or maybe primarily the serial entrepreneur Malcolm Bricklin – to set up a dealerships to sell trucks imported from India). That's really small stuff, from the perspective of the financial needs of a car assembler. Much more important is that a dealership pays for new vehicle inventory, signage and replacement parts inventory and provides the necessary real estate. That is a crucial source of working capital for a manufacturer, because the factory is paid cash when a car rolls off the assembly line, whereas parts suppliers are paid a month or three (and workers a week or two) in arrears. Remember, too, that dealerships frequently hold two month's of inventory. Under its current structure Tesla will need to fund that directly.
   2. It may not be a big issue when they restrict themselves to a low volume of hand-assembled cars. It won't be trivial when they want to run a proper assembly operation.
2. 1. Moving to volume business will also require making provision for repairs. That may not be a big issue when its market is limited to a handful of states and is of high-end cars. They and their cars' owners can wait for a technician to be dispatched, or the car transported. That won't work if they want to move away from the supercar end of the market, because their vehicles will be means of transport, not playthings. Would-be purchasers won't want to wait a week or more to get a problem looked at. I think Tesla underestimates the challenge (cost!) of directly developing a dense network of repair facilities.
   2. In the old days, the local mechanic could do the actual work. But as Kevin Borg (a historian of the independent service station at James Madison University in Virginia) emphasizes in recent work, even the most skilled of independent service technicians lacks the training and equipment for working with the computers and high-voltage electrical systems of a vehicle such as a Tesla. To put it simply, they are fundamentally mechanics, experts in traditional mechanical systems, and a Tesla lacks much of the appurtances of an internal combustion engine powered vehicle.
3. 1. Historically the "factory" has been abyssmal at controlling inventory and even worse at handling tradeins. Think of Ford's disastrous attempt [1998-2001] under Jacques Nasser at Ford to buy up independent dealers and run their stores directly in several markets where state franchise law allowed direct sales (eg, Oklahoma City). Dicke's history of the early days of automotive distribution tells the same story. The bottom line is that the factory bleeds, and the longer it tries, the more money it loses.
   2. Now the rise of multistore dealership groups suggests that at least some people have figured out how to run stores under hired general managers rather than owner-operators. So maybe there is more know-how available. However, such dealership groups – the AutoNation and Penske's of the world – still account for but a small share of total US vehicle sales. I remain skeptical.

Ford in its early days had time to experiment; it wasn't until the early 1920s, after DuPont took over GM, that Ford faced a serious rival. They had time to recover from mis-steps. Tesla won't have that luxury.

...mike smitka...

Dicke, Thomas S. (1992). “From Agent to Dealer: The Ford Motor Company, 1903-1956.” In: Franchising in America: The Development of a Business method, 1840-1980. Chapel Hill: University of North Carolina Press, Chapter 2, pp. 48-84.

Lies, Damn Lies, and Statistics!

David Ruggles
See also Cliff Banks article in Wards

As I watched the Senate hearings today on CSPAN my blood boiled. When asked about the money they would save by cutting their dealer count these guys, Henderson (GM) and Press (Chrysler), engaged in some serious obfuscation. They asserted that by swapping an "under performing" dealer for a "performing dealer" they would pick up the gross profit of the additional sales of the new "performing" dealer. These calculations of the difference between what they got and what they felt they were entitled to makes up the bulk of what they claim the rejected dealers "cost" their companies.
I have a little experience in this area. I have operated dealerships in a number of markets. As a consultant I have visited hundreds of dealerships and worked closely with them. The best dealers are those who have structured their business in such a way as to be less vulnerable to the inevitable downturn in either the new vehicle market or the times when the offerings of their manufacturer weren't well accepted in the market. These successful dealers learned to develop their pre-owned business and other profit centers, and they probably brought in other manufacturer makes to help cover their fixed costs in the event of a market downturn.
These dealers are typically still profitable, despite our difficult sales environment. These are precisely the type of dealers targeted by Chrysler and GM.
Markets are not created equal. To understand the concept, think in terms of MSR, which stands for Minimum Sales Responsibility in the Chrysler business. GM has its own terminology, but the same meaning. MSR is where a manufacturer's national market share percentage is applied to the total new vehicle volume in a specific dealer's market. Any deficiency – shortfall from the target – is what a manufacturer views as lost sales. They can calculate the gross profit they would have made had the dealer hit its MSR. But now they appear to count it as a cost in justifying the arbitrary termination of dealers and their employees. There are additional assumptions. The gross profit they calculate is the margin they make when they sell the a new vehicle to the dealer. The dealer has to sell it at retail to make money themselves, which isn't always possible. MSR also varies by locality; it is certainly possible that a dealer who exceeds MSR in one market would underperform in another.
The fact is, Chrysler and GM resent dealers who have managed their business in such a way as to not be overly dependent on selling their products. Many rejected dealers have been targeted as a result of their business acumen. In addition, Chrysler and GM are moving to force more expense onto their retained dealers. GM has sent out "participation agreements" that any dealer wanting to go forward must sign. It effectively replaces the franchise agreement, forcing dealers to agree to do anything and everything, or else. Don't sign, and the dealer is terminated. GM and Chrysler want more elaborate and expensive facilities. The also want exclusivity in those expanded facilities, meaning the manufacturers won't allow competitive makes in these facilities, even though they are purchased or leased by the dealer, NOT the manufacturer.
Normally, dealers would be protected from these types of unreasonable demands by state and federal franchise laws. But GM and Chrysler are taking advantage of their bankruptcies to avoid these restraints. They are showing why these laws existed in the first place - there is a long history of franchisors abusing franchisees, once the franchisee has money in the business that they can't extract. The auto industry isn't unique, but each store represents a far larger investment than in fast food or most other franchising. Congress and the states had made such blackmail illegal; now Chapter 11 is being manipulated to allow it.
I have a friend who had a Chrysler-Jeep operation yanked from one store, and a Dodge operation from another. Now Chrysler can give them to a competitor. These yanked franchises didn't fall out of the sky, good money was paid for them. Chrysler wants to exact a 3 million dollar building from the other dealer in return for being granting it the franchises. The dealer who was NOT terminated was not selling near their MSR, so there must be other motivations. It will be poetic justice if the yanked Chrysler, Jeep and Dodge franchises languish for lack of a party willing to invest that much for a new facility. Time will tell.
According to Chrysler's Press the distribution costs per vehicle amount to about $1000. Of course, each vehicle bears its proportion of these costs regardless of which dealer they were shipped to. In Press' argument this cost would be less if they could replace under performing dealers with (fewer) performing dealers. But these costs aren't related to the number of dealers – they represent the money spent to develop and maintain the software in the first place.
Furthermore, neither executive mentioned the costs their companies have transferred to the dealer. While claiming there were substantial costs associated with the software and hardware related to their dealer communication IT package, Press neglected to mention that each dealer is charged about $2600 a month for this. He failed to mention that there really are very few, if any, field people these days, as dealer contacts are made by email and telephone instead of actual in-store visits. There was a concerted effort to overstate costs and avoid altogether any mention of how much of these costs are actually reimbursed by dealers. In fact, studies show that each dealer represents POSITIVE cash flow BEFORE they buy a vehicle or a part!
I've been frustrated by previously not being able to determine who made the decision to cut dealers, rather than to allow natural attrition to thin out dealer ranks. (That attrition rate is high at present!) It is hard to believe that Henderson and Press have that little understanding of the auto business. I have to conclude that the initiative to lower the dealer count is driven by the Task Force, who think Toyota's business model is what everyone should emulate. The Task Force may be made up of restructuring geniuses, but they have little understanding of the auto business. Their profession means they are mostly North Easterners who may not even own a vehicle, and are not oriented to the issues of smaller businesses. But when a dealer closes, it likely results in a bankruptcy in which a family's life savings are wiped out. It's not just a job loss. The Task Force doesn't seem to understand this. Closing dealerships will cost sales for Chrysler and GM, something they can ill afford. And the ill-will it generates will cost them a lot more than any potential savings.
Imagine Gillette volunteering to give up shelf space space at the super market to Schick! It's the same principle. Foreign competitors looking to expand their dealer base will scan the ranks of rejected GM and Chrysler dealers. If not for the recession, that would save many of the terminated dealers.
In the meantime the "task force" is driving the bus while all parties deny any micro managing by the government.
But remember: as bad is it is, it's better than liquidation! Those who think Chapter 11 for GM and Chrysler should have been declared last summer have forgotten the financial crisis. To operate in Chapter 11 still requires financing, and for almost a year now that has only been available from the US Treasury. The Task Force is necessary, but the specialized nature of their skill set is apparent. The faster these two firms exit Chapter 11 and the Task Force stops calling the shots, the better.

More on Dealers: My Opinion in NYT

Mike Smitka

Here are a series of brief items in the New York Times "Room For Debate" online forum on their Opinion page: Link here. My contribution starts:

G.M.’s bankruptcy could still unravel unpleasantly. It’s a big customer for the supplier base, and they’re on the edge. Chrysler’s dealers got 26 days’ notice. G.M.’s franchises don’t expire until October 2010. But that’s remote from our everyday experience...

In Defense of Dealers

A few years back Michael Dell was quoted as saying he thought the auto industry should adopt elements of his “build to order” PC business model. He predicted that consumers would someday purchase new vehicles directly from the Manufacturer. Obviously, he didn’t put much value on what the Dealer adds to the Consumer / Manufacturer equation. But after making a pass at Asbury Group Mr. Dell is now a Dealer himself, having partnered with a former head of Sonic to buy dealerships. While we haven’t heard much about that venture recently, we do recall Mr. Dell’s comments about Dealers being an unnecessary and expensive link in the distribution chain. Not long after, Mr. J. D. Power made a similarly negative comment in an interview with the Wall Street Journal and was greeted with tremendous blowback. He was rumored to be a pariah at his company’s own hospitality suite at that year’s National Auto Dealer Association convention. It was not long thereafter J. D. Power and Associates came to be owned by the McGraw Hill Companies.
It seems it has become common for self appointed experts to lecture the industry on how to best retail and service new vehicles. We recall Ford Motor Company’s ill-fated attempt at being a Retailer. Ford purchased all the Ford Dealerships in a number of markets, including Tulsa and Oklahoma City. This experiment took place under the Jacque Nassar regime and provided additional evidence that manufacturers probably don’t know how to retail new vehicles profitably. Ford couldn’t make the venture work even as they owned all the Ford stores in the market! The Ford Auto Collection experiment, and the Saturn experiment at GM, didn’t burnish the concept of “One Price Selling” either. After their short and costly experiment, Ford decided it was better to sell their Dealerships back to genuine Retailers.
People outside the business typically think the secret to success in auto sales is to keep cutting the price and make it up in volume. Real Dealers know they have to make gross profit wherever they can. During their time as Dealers, Ford focused on selling new vehicles. After all, Ford is a Manufacturer. A Dealer knows that selling new vehicles is likely to be a losing proposition at times, especially Detroit 3 Dealers.
They structure their business accordingly. For that reason they learn to make up profit in their other departments. This allows them to sell new vehicles at a net loss when necessary, but still maintain overall profitability. Ford thought they could increase volume with “One Price” and regarded the pre-owned business as a necessary evil. The result? They actually achieved lower new vehicle sales at lower gross profits than before, and gave their pre-owned business away. It’s no wonder they didn’t make money!
Now the “authorities” in charge of the economy assert that GM and Chrysler would be better off with fewer Dealers, as if Dealers add significantly to a Manufacturer’s costs. This is not to say there hasn’t been significant “over-dealering”, especially in metro markets. But “over-dealering” impacts Dealer’s profitability, not the Manufacturer’s.

The Other Side
Let’s look at it from a Dealer’s perspective. Dealers these days have typically been pressured by their Manufacturers into ever more expensive and expansive facilities, despite the fact that a consumer’s Internet screen is now their “showroom” of choice. More and more consumers go to the “brick and mortar” Dealership to view inventory, acquire information, take a test drive, and perhaps get a price quote. The consumer then goes back to their PC to obtain price quotes on their desired vehicle. A Dealer’s conventional sales staff is often competing against its own Internet department, as well as other Dealers, when it comes to price! Moreover, new vehicles are pretty much a commodity these days. An excellent book on the subject is Dale Pollak’s Velocity. He points out that the new vehicle business has been an “efficient market” for years. To economists, an “efficient market” is one where both buyers and sellers have equal information and neither has any significant advantage. According to Wikipedia, “The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.” In other words, there is significant downward pressure on Dealers’ new vehicle gross profits and they are often a loss leader. Velocity is primarily about the pre-owned market, but the principles of market efficiency have applied to new vehicles even longer than to pre-owned.
The current discussion in Washington includes forcing GM and Chrysler to shed Dealers as a condition of receiving “tax payer backed” loans. For some reason, some members of Congress think getting rid of Dealers will save money for GM and Chrysler. They obviously don’t know that once established, there is very little, if any, cost to the Manufacturers for their Dealer networks. As a matter of fact, Dealers are the Manufacturer’s customers, not the buying public. The buying public is the customer of Dealers! Is it logical to try to increase sales by reducing customers?
In addition to selling new vehicles and parts to their Dealers, the Manufacturers also sell them special tools, equipment, furniture and numerous other expensive programs. The Manufacturers have transferred immense costs and risk to their Dealers. The risk of real estate, receivables, inventory and inventory financing is all born by Dealers, not by Manufacturers. In fact, a recent study commissioned by NADA stated, “Far from being a burden to the Manufacturer it represents, the Automobile Dealer supports the Manufacturer’s efforts by providing a vast distribution channel that allows for efficient flow of the Manufacturer’s product to the public at virtually no cost to the Manufacturer. The independently owned and independently financed franchised Automobile Dealer network is a critical asset to the Auto Manufacturers. U.S. Auto Dealers have $233.5 billion invested in their businesses. This capital is supplied by 20,700 independent dealerships that employ and train over 1.1 million people.” According to Dr. Michael Smitka, Professor of Economics at Washington and Lee University and an auto industry expert, “Dealer profitability based on their $233 billion dollar investment and a reasonable 8% return should equate to an 18 billion dollar return for Dealers in aggregate. We’ve seen no evidence that target has been met over the years.”
Further, Dealers provide the resources to stock inventory. They take trade-ins. They arrange financing. They collect and pay billions of dollars per year in taxes. Combined, they represent 20% of all retail sales in the U.S. Unknown to the general public, Dealers collectively have more money invested in their business than their Manufacturers have invested in theirs! Someone needs to explain to me how a Manufacturer can morally and/or legally push major investment and risk on their Dealers/Franchisees and then arbitrarily stop supplying them with product, outside of bankruptcy.
GM killed Oldsmobile by first starving it for product. What was once GM’s most profitable division received “me too,” “badge engineered” vehicles to sell, at a higher price than the same vehicle from other GM divisions. At the same time they backed these less than wonderful vehicles with a marketing campaign that stated, “It’s Not Your Father’s Oldsmobile.” This only further alienated their already aging customer base but failed to turn on younger buyers to their “me too” vehicles.
The money that should have been invested to bolster Oldsmobile was spent on a revolutionary new idea named Saturn. Saturn NEVER made money and Oldsmobile died a slow death. But at least Oldsmobile Dealers received a measure of compensation from GM. It is reported to have cost GM over a billion dollars to shed Oldsmobile, in yesterday’s dollars.

The Upside to Saturn
The best thing to come out of Roger Smith’s Saturn experiment is the Saturn Dealer network and their franchise agreement. This franchise agreement is unique in the U.S, but common in other some other countries, including Japan. It grants distribution rights for an area or region, rather than an individual market. GM has refused to allow Saturn Dealers to dual with other makes. A Dealer friend once said, “When you can’t pay the rent, you have to take in boarders!” But GM has denied this option to Saturn dealers despite the fact they haven’t provided vehicles to Saturn Dealers that the market wants in enough volume to allow its Dealers to be viable. From the beginning they were provided a line of mostly “tepid” vehicles to sell. While the recent Aura and Sky are great vehicles they haven’t been enough to save Saturn!
Besides, the Detroit 3 have never been able to consistently make money selling small vehicles. Consumers had some renewed interest in Saturn’s offerings when fuel prices spiked but that quickly waned. Imagine the result if the Detroit 3 were to design and build only smaller fuel efficient vehicles, as mandated by Congress, and the price of fuel stays low.
Nevertheless, Saturn Dealers are a resourceful bunch and have learned to survive by being excellent operators, focusing on the pre-owned and service ends of the business. They “kill their customers with kindness!” Now they have officially been notified that they will be starved for new products and will soon be phased out. Let’s hope their innovative franchise setup and professional Dealer body attracts a buyer that gives them the opportunity to represent a line of compelling vehicles, whether they be from China, India, Italy, or wherever. I wonder what might happen if Fiat decides they are better off buying Saturn instead of partnering with Chrysler? Saturn Dealers all have substantial investments in facilities that have little value if a successful automotive franchise isn’t operating in them.

Beyond Suburbia
We should also have a special appreciation for “country” Dealers. These Dealers are also resourceful and have learned how to make money in the pre-owned and service business. This has been out of necessity as they typically have not had access to any real quantity of their Manufacturer’s “hot merchandise” when their OEM produced a “winner.” Many have become dependent on their Manufacturer’s Certified Pre-Owned (CPO) offerings. Without a franchise that allows them to buy CPO caliber “program vehicles,” their futures are in doubt.
What does an Auto Dealer do for a community? Aside from local employment, local service, safety recalls, warranty repairs, local charitable work, etc., Dealers collect Sales Tax! A portion of that Sales Tax goes to local government. If a Dealer goes out of business in a community and vehicle buyers are forced to drive out of the locale to make their purchase, the local tax revenue stays where the vehicle is purchased, depriving the previous municipality of its tax revenue. This is a major issue! There are many circumstances where local government has provided financing and other support to maintain a local Dealer and its associated tax base. Imagine a municipality guaranteeing a loan for a local Dealer and the Dealer’s Manufacturer arbitrarily cancels or terminates the franchise agreement or stops supplying product. In this case the Manufacturer probably forced the Dealer to make substantial investments before shutting off product. I can hear the attorneys licking their chops.

What’s Next for the GM & Chrysler?
GM and Chrysler are between a rock and a hard place! They are afraid of Chapter 11 (re-organizational) bankruptcy. They feel few consumers will buy a vehicle from a bankrupt Manufacturer with no real assurance of warranty or resale value. If they don’t go Chapter 11, they are obligated to honor their contractual agreements, including their franchise agreements.

On a macro level, a Manufacturer bankruptcy would drop billions of dollars of pension and health care obligations on the federal government. The United Airlines bankruptcy dropped 6.6 billion dollars on the Pension Benefit Guaranty Corporation! (read that Federal Government.) Imagine GM, Chrysler, and a slew of suppliers hitting that system at the same time. The PBGC was already 23 billion dollars in deficit BEFORE the record UAL bankruptcy. It’s no wonder the government is proving fairly easy to work with for two of the Detroit 3.

On the Bright Side
Fortunately Auto Dealers do have some “aces in the hole!” They have protection from state AND federal laws protecting Dealers and/or Franchisees from their suppliers. These laws are based on “fairness” and cannot be merely swept away by mandate from Congress, a Car Czar, or a committee. Auto Dealers have effective lobbying groups in the form of their state trade associations, Political Action Committees, and most importantly the National Auto Dealer Association. Dealers are victims of many of the circumstances that led to the demise of their Manufacturers, but Dealers had nothing to do with the melt down of the U.S. financial system that dramatically impacted them. They had nothing to do with the sudden spike in fuel prices that rendered much of their inventory “sale proof” and decimated the value of their used vehicle inventories.
Dealers don’t dictate to their Manufacturers what to design and build. Many are currently victimized by Manufacturer sales incentive programs that require the Dealer to order additional vehicles for inventory as a price of admission to the program. These programs may serve the Manufacturer’s purpose but are catastrophic to a Dealer who is sitting on a 150 days (or greater) supply of inventory.
At the same time, the same Dealer is probably facing the prospect of having to “curtail” floor planned vehicles as a result of frequently arbitrary and frivolous mandates from lenders - often the Manufacturer’s captive. This comes at a time when working capital is a most precious commodity. This practice often puts the dealer in the position of having to decline program participation and face the market with a serious cost penalty versus other Dealers selling the same brand. Many of these Dealers are already on “finance hold” due to too much inventory and/or deterioration of their balance sheet. So now they face having a serious cost penalty in selling the inventory they purchased in good faith from their Manufacturer months ago.
Many Manufacturer programs are frequently designed to give the OEM a “free float” on the Dealer’s working capital while at the same time demanding immediate payment from the Dealer for the monthly parts statement.
In summary, Dealers are not only important, but absolutely necessary to a Manufacturer’s survival and ongoing success. Shutting down an entire division may make economic sense to a Manufacturer, if they cannot afford to design and build vehicles to supply that Division’s Dealers. But it will be quite expensive to do so. Merely thinning out Dealers as a method of increasing Manufacturer profitability is a totally flawed concept and strategies designed to force Dealers out of business should be dealt with sternly.

A reprint of the Ruggles Report February 2009

Follow the Money

The news today is of efforts to cut the cost side of the OEMs, Chrysler of course but also General Motors. Is this good news? To frame that question we need to do two things. First, what of the revenue side? Second, what of the overall value stream? – after all, the OEM slice is a quarter or less of total, not including the aftermarket, consumer finance and so on. The way I read it, we do not yet have any good news, because focusing on costs while revenues slide is chasing a will-o'-the-wisp. And the upstream and downstream segments are on the brink of a deep precipice – but I'm not sure which side of the brink.

To my mind, the key variable at the moment is the residual (resale) value of a vehicle. As long as it remains low, it cuts into the arteries, and staunching the bleeding is hard. A low residual value means that purchasers are more likely to be "under water" on their current vehicle, with a trade-in value less than their loan balance. A low residual value means that leasing is dead, and a straight loan has to be priced higher, to cover the poor value of a vehicle as collateral (never mind the current recession-driven risk that the borrower's income may disappear). And a low residual value means that even if the buyer will pay cash (or has equity in their current car), they will shy away from a great vehicle in favor of one that because of its nameplate will hold its resale value. [I will post this before digging up sample numbers, say of a Toyota Titan and a comparable GM pickup – comments, please!] If the 4-year-out resale value of one vehicle is 50% of purchase price, and of another is 30% – well, no OEM can afford to discount their vehicles up front enough to offset the different.

So how to pull up residuals? Unfortunately the cutback in fleet sales at GM is too recent to have cut the flood of used cars that has depressed their residuals over the past several years. [Or so I assume -- ADESA or various used car guides could provide data.] In a year or two the impact would have been tremendous, had the recession not intervened. After all, GM has the car of the year and good ranking in the JDPowers quality surveys. (Ditto the combination of VEBA and retirees hitting age 65 to handle legacy costs on the cost side come 2011.) But luck was not with them. Maybe the biggest help the government could give is using its purchasing dollars not on new vehicles but on 2-, 3- and 4-year old vehicles to pull up their resale value.

Low residuals hurt other portions of the industry. If a dealer closes its doors, the normal franchise agreement obligates the OEM to repurchase inventory at cost. For the bank that finances this inventory ("floorplan") that is crucial. No bank is prepared to accept 200 cars on a lot when a loan forecloses. But if GM faces Chapter 11, it would no longer be obligated to make dealers (or their lenders) whole. Now if the residual value of GM vehicles was high, lenders could at least figure out what such collateral would be worth. As it is, no lender in their right mind would extend additional financing to a GM dealer (much less a Chrysler dealer). And no dealer would order a new car. That means that these companies will have zero revenue, because even if consumers flock to dealership lots, GM sells cars to dealers, not consumers.

That's of course the downstream viability story: GM may not have any dealers left, due to the collapse of financing, and they certainly won't have dealers buying cars. Costs cuts can never offset such revenue cuts. Of course if GM goes, and there is a massive firesale, Honda and others will face crisis, too, because consumers will have the choice of a new GM vehicle at 50% off – who knows? – and why in such a situation would you buy a used Honda? or a new one?

Now the upstream parts sector is in as bad of shape, maybe worse. While GM is closed they will be ordering no parts (remember that the factories of parts firms employ about 3x the number of manufacturing jobs at GM and its peers). With no orders, no revenue. Now the strategic imperative for suppliers the past decade was to diversify their customer base. But how can they keep their factories open if Honda and Toyota are 25% of their revenue, and GM and Chrysler 75%? And how can they fund the engineering effort on new vehicle models and basic R&D needed to garner orders for vehicles launched in 2012 and 2013, when sales will hopefully have rebounded? I don't think they can. My own feeling is that the downward spiral is not letting up. The tide is still building, and the whirlpool is getting harder to escape.

So, even if a bailout is arranged that temporarily keeps GM out of bankruptcy, if the downstream and upstream both collapse, well. I want to avoid thinking about what that might look like, and how the industry could start up again. But my quick attempt to follow the money suggests it's flowing down the drain, and the flow is slowing to boot.

thanks to DR and JJH and TK for stimulation

I will try to add numbers later