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CHAPTER 1
MARGIN COMPRESSION: WHY SIMPLY SELLING MORE CARS WON'T BE ENOUGH
Ever since the dawn of the franchise dealer, there's been a fairly simple formula for success. Each year, dealers would aim to do better than they did the year before.
If they could, they'd find ways to increase the gross profit they earned for every new and used retail unit. If they couldn't make more on a per-car basis, they'd focus on growing their retail volumes to produce a higher level of gross profit than they achieved in the prior year.
It's fair to say this sell-more-to-make-more formula has served the car business very well over the past hundred years.
But I believe the formula is quickly running out of gas — and its demise means bad news for nearly every dealer in the country.
The chief culprit is margin compression.
Thanks to the Internet, rising transparency, and a highly competitive market, dealers aren't making as much money on a per-car basis as they used to. What's more, we're not too far away from a normalization of new and used vehicle sales volumes, where the year-over-year increases dealers have enjoyed since 2009 will at least flatline, if not decline.
For dealers, these converging trends will render the old formula for success — that you can make up declines in front-end grosses by selling more cars — highly problematic.
Let's take a moment to unpack and validate these trends.
In 2005, dealers had a stellar year. According to stats from the National Automobile Dealers Association (NADA), dealers averaged 852 new vehicle sales per rooftop, contributing to an annual total of 16.9 million new retail units. Profits were pretty good, too. New vehicle gross profit as a percentage of transaction prices ran roughly 5 percent. With an average vehicle transaction price of $28,400, the front-end gross profit average ran $1,420.
Of course, the bottom had fallen out of the industry by 2009. Thanks to the economic recession, new vehicle sales dropped to 10.4 million that year (down 39 percent from their 2005 peak). The average dealership retailed 615 new vehicles. Even worse, the gross profits on those vehicles also went south.
NADA data shows that gross profit as a percentage of transaction prices ran 3.61 percent in 2009. With an average transaction price of $28,966, the average front-end gross profit for dealers that year ran $1,045 — a 26 percent decline from the tally in 2005.
Since that time, the industry has gained considerable steam.
In 2011, NADA reported that dealers saw a positive profit in their new vehicle departments for the first time in five years — an achievement that largely owes to the pent-up demand for new cars after the recession.
This blessing of strong demand for new vehicles has only continued.
I vividly remember the mood at NADA's 2014 convention in New Orleans. Dealers had just closed their fourth consecutive year of collectively selling over one million more new vehicles than they had the year before. "Business is fantastic!" was a common refrain. Even NADA's convention theme, "Accelerate Your Business," seemed spot-on.
Sure enough, dealers closed 2014 selling 16.4 million new vehicles, with the average dealership selling 1,003 units for the year. Gross margins, however, didn't fare so well.
NADA reports the front-end gross profit as a percentage of vehicle transaction price in 2014 ran 2.48 percent — which translates to $808 per car, given a $32,618 average transaction price.
By my calculations, these figures mean that dealers saw a 43 percent decline in front-end gross profits in new vehicles between 2005 and 2014. Over the course of the same period, dealers paid 20 percent more on average to purchase this inventory from their factory partners, according to Kelley Blue Book data on invoice prices.
I wish I could report that margin compression has only affected new vehicles through the past decade. Unfortunately, it's wreaking a bit of havoc in used vehicles, too.
In 2005, the average used vehicle transaction price was $14,925, according to NADA. At that time, the front-end gross profit as a percentage of transaction prices ran roughly 12 percent, or $1,791 per unit.
But in 2014, dealers saw an average used vehicle transaction price of roughly $18,700. Meanwhile, the front-end gross profit as a percentage of transaction prices ran 8.6 percent, or $1,608 per unit — a 10 percent decline from 2005.
No matter how you slice it, dealers are investing more to acquire the vehicles they sell, and seeing a smaller return when they retail the vehicles and recoup their investment. This profitdraining trend in new and used vehicles will only get worse.
Why, then, aren't dealers all that concerned?
When I ask dealers about these effects of margin compression, I'll often hear comments like this one:
"Our grosses are about the same as they've always been. Sure, we might be able to do better, but we're selling more cars, new and used. We're having a record year. I don't really see margin compression as a problem."
I understand the source of these sentiments. This dealer, like many of his peers, is banking on the industry's age-old formula for success — if you sell more cars, you'll make your profit through volume.
But I question whether, in today's ever-present era of declining margins, this formula will work for the long haul.
Consider these five factors that are likely to further erode profits for many dealers.
1. Volume limits
Ours is a highly cyclical business. Old car dogs like me can't help but worry that the next downturn is right around the corner. Maybe we'll get lucky. Maybe the industry won't take a big hit due to some kind of shock, economic or otherwise. Maybe it'll be as some analysts predict. We'll see another year or two of incremental growth in new vehicle sales and might even surpass the eighteen million vehicle mark. After that, sales will level off and likely diminish. The key question, though, is how far will volumes fall, and what will the decline mean for dealers who depend on the age-old formula for their profitability and success?
I'm afraid the outlook for these dealers won't be so good. There simply won't be the opportunity to sell as many new vehicles as they're retailing today. Plus there's no assurance that factories will continue to help offset front-end margin declines through stair-step bonus money. In my view, it's not a question of if these factors converge but how soon it'll happen. When it does, margin compression will no longer be an abstract concept; it'll be a very real and serious problem.
2. Interest expense
When I was a dealer in the 1980s, interest expense was a much bigger deal than it is today. We routinely paid interest rates above 10 percent when we borrowed money for facilities or floorplan. Today, dealers pay a fraction of yesteryear's interest expense, and they aren't complaining.
But while I don't believe we'll see double-digit interest rates, there's only one direction they can move from their historically low levels, which is up.
As the Fed makes these adjustments, many dealers risk being overexposed in two key areas.
The first is floorplan expense. In recent years, top-performing dealers have turned factory floorplan programs into moneymakers. With ultralow interest rates, and a focus on inventory velocity, these dealers have turned an expense into a profit driver. Even less investment-efficient dealers do OK. For them, floorplan expense is a break-even proposition, as they use faster-selling units to pay down the interest costs of slower-moving inventory.
The bottom line: Floorplan expense hasn't burdened the balance sheet much in recent years — an operational benefit that will diminish in direct proportion to the size of any interest rate increase.
The second risk area relates to the interest on loans dealers use to finance facilities and real estate. Being the gamblers they are, it's not uncommon for dealers to take out floating, rather than fixed, rate loans. It's been a good gamble in light of historically low rates. But the prospect of an interest rate increase has spurred astute, forward-thinking dealers to fix these arrangements to minimize future exposure.
3. F&I regulation
As front-end profits decline in new and used vehicles, dealers have leaned on their F&I offices to help them achieve the level of profitability they expect from their variable operations. In 2005, F&I revenue accounted for about 25 percent of gross profit generated in variable operations. In 2016, the figure ran north of 40 percent, and it's still climbing.
That's really good money.
But, looking ahead, I suspect it'll be difficult for dealers to expect a similar trajectory of increased profit production from F&I, particularly as federal agencies, like the Consumer Finance Protection Bureau (CFPB), put heat on lenders to limit dealer reserve markups and question the sales practices and transparency of F&I products.
At the moment, NADA is working to limit CFPB's authority and oversight of F&I practices.
But even if NADA succeeds, it seems to me the die is cast. I wouldn't be surprised if the terms of American Honda's settlement agreement with CFPB don't become more or less standard practice for the industry — a development that will affect every dealer and cause those who over-rely on F&I income the highest level of profitability pain.
4. Competition
In my work to advance Velocity Method of Management principles in new and used vehicle operations at dealerships, I've discovered you can divide dealers into three groups. The top performers account for about 10 percent of all dealers. They are progressive. They keep a close eye on future trends. They have a clear view of how much margin compression has affected their performance and profitability. Some have already begun to actively combat margin compression across their dealerships.
The next group makes up another 10 to 20 percent of dealers. They don't lead the pack, but they adapt to change more quickly than most. They, too, recognize margin compression as a risk but aren't necessarily sure how best to address it.
The third group, the remaining 70 percent, are more reactive to market trends. They like proof before they proceed. It often takes a crisis to spur them to action. They're like the dealer who doesn't view margin compression as an imminent threat.
As sales volumes diminish, and margin compression becomes more profound, the dealers in the top 10 percent are going to have a field day. Their efforts to curtail margin compression today will give them a competitive advantage when the market becomes more challenging tomorrow. They're the ones buying up the competition and using ever-larger economies and efficiencies of scale to their distinct advantage (more on this in chapter 13).
The success of these dealers will largely come at the expense of dealers in the third group. Unfortunately, they will work harder and harder, applying the age-old "sell more, make more" formula and hoping for success that just doesn't seem to materialize. Over time, they will see, in painfully clear terms, how far this fractured formula falls short as viable retail strategy in today's retail environment.
5. Ongoing margin compression
As noted previously, you can trace the root causes of margin compression in automotive retail to the Internet. Consumers now have unprecedented levels of efficiency and transparency as they look to buy, sell, and service vehicles. By their nature, these market dynamics are disruptive to dealer margins.
But the same is true in every other retail sector. The Internet has made it harder for virtually every retailer to make more money. Those who do find the gains flow through increased efficiencies, not just selling more stuff.
Dealers should not make the mistake of thinking that margin compression will somehow, someday, just go away. As with any business today, particularly one as mature as the automotive retail industry, margin compression is an ongoing fact and an increasingly troubling way of life.
AN EFFICIENCY- AND PROFIT-FOCUSED FORMULA
In light of all the evidence that margin compression is here to stay, and dealers won't always be able to count on year-over-year increases to remain profitable and prosperous, I suggest that dealers rethink the age-old, sell-more-and-make-more formula for success.
I'd rewrite the formula this way: You can make up the decline in front-end profit only if you sell more cars more efficiently.
This new formula is, in fact, the strategy that a growing number of top-performing dealers — the 10 percenters — have already begun to pursue at their dealerships.
These dealers recognize that while they can't necessarily stop margin compression, they can fight its harmful effects by changing how they do business. Their new way of doing business emphasizes technology-driven economic and operational efficiencies in all corners of the dealership. The dealers regard this strategy as the foundation for their future profitability and prosperity as retailers.
How does it look? Here are broad strokes that apply to four critical assets for every dealer.
Asset 1: Customers
Dealers have traditionally engaged customers on terms more favorable to the dealer than those they serve. You can't get beyond the asking price for a vehicle unless you come into the showroom. In the dealership, the sales process is built on long waits for customers that follows a "hold 'em 'til you fold 'em" strategy. In service, it's often left to customers to set appointments and to find out when their vehicle is ready and how much repairs will cost.
All of these inefficiencies can be eliminated through technology-driven processes that help dealers serve customers on the terms they prefer. The elimination of these inefficiencies would engender a higher level of customer loyalty and satisfaction. Dealers would benefit from improved productivity and profitability from their people (e.g., sales associates, managers, service advisors, even technicians), which yields a more positive financial outcome for the dealership.
Progressive dealers have already begun retooling their dealership people and processes to achieve a higher level of customercentric efficiencies. In this way, they are fulfilling the promise of the new formula for success — profit improvement follows the elimination of long-standing inefficiencies.
Asset 2: Inventory
Currently, one of the most inefficient uses of dealer capital resides in new and used vehicle inventories. In 2016, the average age of new vehicles in the majority of dealership inventories ran higher than one hundred days. By contrast, top-performing dealers achieve an average inventory age around seventy days — a benchmark that represents a 50 percent improvement in new vehicle inventory and sales velocity. These dealers have upended the traditional thinking that aging new vehicle inventory isn't a problem. They've adopted technology and tools to help them manage the complexity of inventory decisions — orders from the factory, dealer trades, add-on options, merchandising, pricing, and so on — in a manner that maximizes profitability and return on investment. These dealers have a clearer view of current market demands and optimize their inventory investments to meet them, even when factory allocations and restrictions make the job more difficult.
In used vehicles, dealers are doing a much better job than they have in years past. There's widespread recognition that aged vehicles are really symptoms of profit-draining inefficiencies. The best dealers retail 55 percent or more of their used vehicle inventories in less than thirty days. They understand that this more efficient and faster pace of inventory velocity translates to a higher level of profitability, sales, and total return on investment for the dealership itself. Still, there's room for improvement, particularly as the used vehicle market in the coming years will see increased supplies and a higher level of volatility.
Asset 3: People
As the industry has emerged from the 2007–2008 downturn, dealers have not been as efficiency minded or judicious as they have increased capacity and staff to meet growing market demand for new and used vehicles. Only a small minority of dealers tore up the traditional playbook and processes that inherently make people less efficient and productive in the showroom and beyond. Employee turnover in variable operations remains a costly, inefficient problem for dealers, even if these costs don't show up directly on dealership financial statements. I've devoted chapter 6 of this book to what I call human capital management efficiency. We'll dig deeper into the ways dealers can directly tie increased employee efficiency and productivity to profit improvement for the dealership. Suffice it to say, however, there's much, much work to be done.
(Continues…)
Excerpted from "Like I See It"
by .
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