As we’ve discussed in previous months’ Intel Reports, the pace of change coming to the automotive retail channel is accelerating. If you blink, you may miss big news that potentially impacts the franchised dealer model.
This month I want to recap key recent news that dealers should be monitoring.
First up, there’s no sign that physical dealership buy/sell activity is slowing down anytime soon.
Lithia Motors has been the most ravenous of the public acquirers, with a stated goal to get to 500 rooftops and $50 billion in revenue before they’ve built out their planned footprint. Lithia’s aggressive pace of acquisitions has provided a floor for valuations in the market.
Just this last week, Lithia announced the purchase of 10 dealerships across southern Florida and Nevada, which will add $950 million in expected annualized revenue.
The U.S. dealership buy-sell market so far is tracking at a similar pace to a record-breaking 2021; last year was considered the biggest year for store acquisitions in history.
In parallel, valuations of physical dealerships remain at an all-time high.
From my perspective, it’s not likely that valuations will get much higher than they are today. Interest rates on acquisition financing are rising and the elevated stock prices of the public groups are well off their highs. When natural acquirers like Lithia have satisfied their appetite and filled out their planned footprint it’s very likely that valuations will start to regress back towards historical levels.
High inflation and fuel prices, low consumer sentiment, rising interest rates and declines in the stock market may actually speed us back to more normalized valuations.
But for now, these record-high valuations are being applied to record-high profits, largely attributable to a lack of new-vehicle supply. Many dealers are taking the opportunity to translate these excess profits into acquiring more physical stores.
While the dealer principals I speak with are generally targeting only under-performing stores - where they can justify paying higher valuations applied to sub-optimal profits - I imagine some of the buyers in this current environment will eventually feel “Buyers Remorse” when valuations inevitably fall back down to earth.
OEMS CONTINUE TO MOVE THE BALL
In last month’s Intel Report, we noted a general movement towards more of an “Agency Model” in other parts of the world.
The agency model, which is being talked about more and more in the press but is not very well defined, is an evolution away from a more typical franchised dealership model to “agents” who sell products on the OEM’s behalf. This model is more attractive to the automakers because they see the potential to reduce operating costs (primarily marketing and inventory expense), eliminate discounting, and normalize the customer experience.
Rather than a full “Direct to Consumer” (DTC) model like Casper or Warby Parker, which is what new EV automakers like Rivian seem to be executing, an Agency Model is a bit of a hybrid between full DTC and the historical franchise model.
Many of the big consulting firms are pushing the agency model for the benefit of OEMs.
Last month we noted that Stellantis said it would end all current sales and service contracts with European dealers for its 14 brands, effective June 2023. And Mercedes-Benz announced plans to cut 15 to 20 percent of its dealerships in Germany, and about 10 percent of their dealerships globally, as part of a broad overhaul of its distribution network.
Some concern exists among dealers that OEMs may “spin-off” the EV divisions of the legacy business and try to apply a different arrangement/agreement with their dealers/agents. This is why VW’s announcement of the Scout brand raised eyebrows, as did Ford’s announcement at NADA this year about the separation of their EV and ICE divisions.
With larger dealer groups, the receptivity to the agency model increases, while the concern goes down. This is due to the fact that they are more likely to be the preferred channel of distribution (vs. smaller players), will have more say in strategic decisions, and have a greater influence and “voice at the table”.
I expect we will see continued “creep” towards more of an Agency Model here in the U.S.: online ordering/reservation of new EV models, reducing and capping commissions on certain models, less control over inventory, fewer incentives, etc.
OEMS TO CONTROL LEASE-END VOLUME?
This month, very interesting news from Ford Motor Company who announced that they have stopped allowing customers in most states to purchase their electric vehicles at the end of a lease, a policy they say will help manage EV battery recycling.
For example, Ford Credit said customers who lease an F-150 Lightning, Mustang Mach-E or E-Transit must return the vehicle when the contract is up and can then renew their lease with a new vehicle if they choose.
Preventing the consumer from being able to buy the unit at the end of their term does make a lease feel a lot more like a subscription product.
While Ford is communicating this initiative as a way to help reclaim the raw inputs into batteries as prices have skyrocketed over the past year, I think there may be other dynamics at play.
I believe this will allow Ford to control residual value risk for new EV models that might have volatile pricing at the end of term. We’re going to see a proliferation of new EV models over the next 18 months, and the OEMs are certainly not going to be able to accurately predict residual values on all of these vehicles. By controlling used car supply, Ford can closely monitor and influence the used pricing.
Both GM (with CarBravo) and Ford (with Blue Advantage) now manage their own online used car websites. By controlling the off-lease volume, they can ensure that unique, attractive used vehicles are ONLY available on their own proprietary sites.
The Automakers have been observing recent used car dynamics, including the fact that most vehicles are coming back at the end of lease term with thousands of dollars of positive equity. Ford will essentially have the opportunity to participate economically in any vehicle coming back with positive equity, instead of surrendering that profit to the consumer or the dealer.
It’s also likely that Ford realizes that battery and charging technology is going to advance so quickly that they may want the option of removing used EVs from circulation that just may not perform competitively versus brand new models being introduced in the future.
If we think about broader implications of this move and anticipating that other OEMs will elect to follow the same path, it will mean far fewer off-lease vehicles available to the automakers’ franchise dealer networks and independent dealerships.
We’ll be watching to see which other automakers announce similar plans over the coming months. I expect we will see many others follow Ford’s lead.
SHRINKING THE FRANCHISE DEALERSHIP FOOTPRINT
A key question is if and how automakers will attempt to reduce the number of physical dealership locations in the U.S.
Certain brands have overbuilt the number of dealerships required, especially as a greater percentage of consumers inevitably become comfortable with purchasing their vehicle sight unseen.
CASE STUDY: CADILLAC
The number of Cadillac dealers in the U.S. has shrunk to 564, as compared to 921 dealer locations just four years ago.
Cadillac required that dealers invest $200,000 towards electrification improvements: things like on-site vehicle charging stations, new tooling, service upgrades, cosmetic enhancements, and training for sales and service staff.
Dealers who opted not to upgrade for the EV transition were offered a buyout package said to have been an amount between $300,000 to nearly $1 million. Some dealers reported low customer interest in EV products, including some dealers located in more rural areas.
With the evolution towards EVs, more automakers may follow suit to shrink their dealership footprint.
It’s also very likely that OEMs will encourage stronger/larger dealers to acquire weaker/remote stores and operate them as satellite locations.
MORE REGULATION COMING FOR F&I?
Last but definitely not least in the recent news cycle, The Federal Trade Commission recently signaled that increased regulation may be coming to dealer F&I profits.
Since the CFPB was largely “de-fanged” during the Trump administration, there hasn’t been much threat about regulators squeezing dealer finance and insurance profits.
The FTC has proposed banning finance and insurance coverage and physical vehicle add-ons that “provide no benefit" and requiring expanded disclosure and consent on such optional products — including a list of prices online.
The agency is also considering cracking down on dealerships' advertising related to the cost of the vehicle itself.
An accompanying news release repeatedly depicted physical additions and F&I products as "junk fees," though the four commissioners supporting regulations acknowledged in a separate statement that "Not all add-ons provide no value."
The FTC's proposed regulations include:
Bans on all products without benefit
Posting a list of all optional add-ons and their prices online
Bans on misleading pricing advertising
Disclosure and declining in writing of the "Cash Price without Optional Add-ons"
"Express, Informed Consent" on F&I products and other add-ons
While most of these regulations are meant to protect against misleading sales practices, it does raise some legitimate questions for every car dealer. The rule proposes regulating an “Offering Price” which is the full amount for which a dealer will sell or finance to any consumer, excluding only governmental charges. The proposal specifically cites cases where low prices are offset by high “doc fees”, and regards advertised prices requiring additional fees as deceptive.
This begs a question about how to apply rules to OEM incentives. Some OEM incentives only apply to financing, for which not all customers will qualify. Other qualified incentives like competitive owners’ coupons and loyalty offers apply to a high percentage of consumers, but not all. If a dealer does not include these incentives, their pricing will look deceptively high instead of low. It will be important for the industry to clarify how these rules will apply to common situations that dealers will encounter.
Violations of the proposed rule would be considered material violations of the FTC act Section 5, which carries a potential civil penalty plus $40k per violation, possibly per day. Civil penalties can range from thousands to millions of dollars. Due to the multi-year requirement for retaining documentation, the potential liability for non-compliance is staggeringly large.
The FTC proposal is open for public comment at https://www.regulations.gov/ and asks that comments be labeled with “Motor Vehicle Dealers NPRM, File No. P204800”.
We will be keeping a close eye on this latest development and if the FTC, or any other government entity, starts encroaching on and threatening dealership profit centers.
All of these issues should be closely monitored by dealerships and have wide implications for the franchise dealership model and ongoing profitability into the future.
BENEFITS OF SCALE
How big do I need to be to weather all of the dynamics in the market? This is a question that I’m getting more and more often from small dealer groups, as the news cycle introduces more uncertainty about the future.
The answer isn’t straightforward but should be looked at from the perspective of:
In terms of cost structure, the scale/size of the public groups does put them at an advantage vs. the average dealerships. Ten to fifteen percent of efficiency in SG&A flow directly through to the bottom line, and provides the public groups with more “dry powder” to acquire stores (or buy back shares).
Another way to look at cost efficiencies is through advertising expenses. In 2021, Carvana spent $479 million on advertising, which is 3-times more than CarGurus. CarMax spent $218 million, while Lithia spent $162 million.
It’s not unreasonable to project that within a few years some of the large dealer groups will spend more than $1 billion per year on advertising. This will make it much harder for smaller dealerships to compete for consumer eyeballs.
In parallel to keeping a watchful eye on their cost structure and using size/scale to centralize and remove costs, dealers might look to diversify across multiple OEM brands. Some of the automakers are moving towards elements of an “Agency Model” at a faster pace than others, and owning a diverse portfolio of OEM brands will allow dealers to naturally hedge against any one OEM becoming more aggressive with direct sales, centralizing inventory, reducing margin per unit sold, etc.
Last, but not least, the more locations you own, and more units sold for any given OEM, the more influence and voice you will have when it comes to the evolving retail model, being prioritized for new car allocations, etc.
RELATIVE SIZE: DEALERS VS. OEMS
The average dealership location doesn’t have much leverage when compared to the size of the average automaker. But by growing through acquisition, small dealer groups can become mid-sized dealer groups, which gains more control and potentially a “seat at the table” in discussions with OEMs about how to shape OEM/dealer strategies and influence the future.
DEALERFUND INVESTMENT AREAS
We are proud to announce that we’ve conducted the initial close of the Automotive Ventures DealerFund, which was created to help dealers navigate through the uncertainty of the next decade by investing in early-stage AutoTech companies that both benefit their operations as well as provide above-average financial returns.
As a result, we are now actively investing out of the fund.
We’ve been spending a lot of time on the road visiting with our dealer investors and are starting to refine their thoughts and feedback into the investment themes for the fund. We will be sharing more on the specific target areas of investment for the fund over the coming months, but so far the broad categories are:
Achieving Operational Efficiencies
What do we look for in terms of investment criteria for companies we target? While we have a number of metrics that we use to “score” each individual investment’s attractiveness, there are three primary criteria that can drive us towards a quick “no” or put a company into the “yes” bucket:
Total Addressable Market (TAM)
Defensibility of Offering
If you're an AutoTech entrepreneur working on a solution that helps car dealerships, we want to hear from you. We are actively investing out of the new DealerFund.
If you’re a dealer who wants to invest in early-stage AutoTech companies that benefit your business, let me know. We are still accepting new investors into the fund.
It’s an exciting time for this industry, and I look forward to working with you to create the future.