May 20, 2006

Used Cars in China: Part 1 – America’s experience with interest rates, leases, and auctions

Filed under: Automotive — Administrator @ 4:55 pm

Today, it is raining in Shanghai. I sort of like these crappy days because it gives my mind a chance to drift away and think about stuff in ways I wouldn’t normally consider (perhaps, alcoholics might call this “a moment of clarity”); regardless, some of my best ideas/insights come to me when I’m most distracted or day dreaming (MTV generation, thank you very much).

Like, for example, I’m now at peace with how I see China’s used car industry playing out over the next decade; and in case you are wondering, this revelation happened somewhere in between a public bus’ side mirror nicking my umbrella out of my hands (classic case of standing too close to the curb) and almost getting hit by a taxi.

The revelation: “Kansas City Shuffle”.

A Kansas City Shuffle is when “…everyone looks right…and you go left.” I guess it isn’t something people hear a lot about as it falls on deaf ears mostly; essentially, the people (or businesses) involved are connected only by the slightest of events – only at a Shuffle’s Tipping Point is the plot truly revealed, but by then the damage has been done.

What the hell does a Kansas City Shuffle and used cars in China have in common? That is a good question – let me explain with another question – ask anyone what the core driver leading up to the proliferation of used cars in the United States and 9 out of 10 people will say “transparency” or “certification” (answers courtesy of the hypnotic multi-million dollar advertising campaigns by both online and office auto dealers and manufacturers); so, yeah, if you side with this camp I believe you’ve just walking into the middle of a Kansas City Shuffle.

Interest rates – that is the answer you should be mulling over in your head – not certification.

You might be asking yourself, why should I care about the catalyst of America’s used car industry and how it may or may not relate to China? The truth is, this blog is a bit specialized, for sure, but the forces that shaped America’s auto industry had a dramatic impact on the very fabric of American society – social, financial, and cultural; why would it be any different in China? From a socio-economic perspective – it’s very relevant to anyone involved in China. From a business perspective – specifically, I’m speaking to investors and entrepreneurs in the automotive space – it is critical to accurately identify the spark responsible for the explosion in America’s second hand car market – and from there determine whether or not China will follow a similar path – for if you don’t your business model will simply be wrong.

The best way to understand what I’m brewing about is to follow me on a trip down memory lane and then, back to the future – your mission, should you accept it is not to become a Scientologist, but rather to better understand how the used car industry in the United States’ developed and how China might track to this. This is going to take a couple days to play out so I’ve broken the blog down into a couple parts (I’m just not sure how many part just yet).

Part 1: A brief history of America’s used car industry – interest rates, leases, and auctions

1918 & Les Kelley: This guy, Les, is credited as one of the first people to truly institutionalize the used car industry. Until the 1950s/1960s, Les’ company, Kelley Kar Company (Los Angeles, CA), was one of the largest used car dealerships, worldwide; but Les is remembered more for his little blue book, Kelly’s Blue Book, a publication listing recommended wholesale values for basically every car manufactured/sold in the US/worldwide, than his dealerships.

Kelley’s efforts aside, the used car business in the US remained nascent until the late 1980s when the automotive tectonic plates dramatically shifted – the profile of used cars changed (younger cars) on the back of favorable financing terms (leasing) and thus a surge in consumer demand (buyer’s market – mucho inventory).

Early to mid 1970s: New car dealers still made solid margins on new cars – there was no need to go downstream and sell used cars – new car prices and interest rates were very reasonable, affordable, and the Japanese (automotive manufacturers) had yet to become a major pain the American automotive manufacturers’ license plate. In fact, the environment was so healthy that consumers were buying a new car every year (this was the norm, not the exception). And, unlike in the 1990s, manufacturers (or OEMs) went out of their way to discourage their dealers from selling used cars since OEMs only made money when dealers sold new cars.

Late 1970s to mid 1980s: The United States saw interest rates spiraling higher and higher (along side fuel) – inflationary pressures forced the price of American made vehicles through the roof, sometimes ratcheting higher 2, 3 or 4 times per year – essentially, the floor fell from under the feet of American automotive industry, or did it? The Japanese automotive OEMs were loving life (thanks to favorable exchange rates and their fuel efficient vehicles) – of course, at the expense of gas guzzling American vehicles.

For example, on Cape Cod, specifically during George Washington’s Birthday (Washington’s Birthday is somehow associated with car sales) the main shopping mall, Cape Cod Mall, opened its doors (literally) to local dealers and hosted a 3 day auto show – during these 3 days, my father, a Nissan/Fiat/Peugeot dealer, repeatedly outsold his American counterparts, selling no less than a month’s worth of cars (the record being 21 in one day) – or about four Japanese cars for every one American car sold.

In spite of inflation, higher rates, and fuel prices, Americans were still buying new cars, just not the same brand of new cars they did a decade or so earlier. The knock on effect, as far as the used car industry was concerned, was absolutely zero – largely because the majority of used cars were expensive and of poor quality (i.e. the market consisted of American made gas guzzling monsters – relative to the new Japanese products the Americans couldn’t compete).

The mid-1980s to the early/mid-1990s:American consumers dramatically changed they purchasing habits – essentially, they stopped buying new cars – full stop. Sure, higher prices were retarding sales, but this was already a factor years before; no the reason new car sales fell off a cliff had everything to do with high interest rates and the negative impact these rates had on significantly elevating car payments (the old practice of paying cash for cars had been sidelined by the popularity of financing). With an American economy less than inspired, rate moving higher, and consumer confidence dropping monthly, the last thing anyone wanted to do was pull the trigger on a new car. But, people still needed cars, and if they couldn’t see themselves in a new car, they could see themselves in a used car, especially at discounts of 30% to 50% below the average new car’s sticker price.

In no small measure, high interest rates forced America into second hand cars, gladly accepting lower monthly car payments along the way. Rather ironically, dealers soon (more so by the 1990s – as you’ll read shortly) realized they were sitting on a gold mine as margins on used cars were (potentially) heaps higher than on new cars. How could that be? Well, in plain English, consumers had no way of knowing how much the dealer paid for the used car as there was no factory invoice or Manufacture Suggested Retail Price (MSRP).

For example, a new car might net a dealer US$500 profit, whereas a used car might pull in four times that. In fact, it got to a point where dealers lost money when they sold a new car, and thus their only source of revenue came from sales of used cars (revenue excludes back-end revenue pools, such as parts and repair services which could account for up to 50% of a dealer’s revs).

As a result, new car dealers started consolidating used car dealerships (used car business is all about scale/inventory, much more so than new car business) and formed super stores specializing in used cars, such as Carmax and Lithia Motors.

Maybe we should take a step back, get our bearings – we’ve come a long way in a short period of time. It took nearly a century to get Americans into used cars; albeit they came grudgingly, they did come and for no other reason than to alleviate financial pain resulting from higher interest rates (car payments). So, now, consumers were happy (they could afford a car), dealers were happy (making money hand over fist), but automotive OEMs were unhappy (on the back of dramatic declines in new car sales) – it was obvious something was going to have to change as OEMs would not allow this environment to persist.

Welcome to the age of automotive lease (circa 1990): What promised to be the fix, or answer to sagging new car sales, actually, did as much for the proliferation of the American used car industry as high interest rates did in shifting consumer purchasing preferences. In no small measure, the “lease car revolution” made it possible for used cars to become a viable business. Essentially, previously leased cars made up the bulk of used cars sold in the United States during the 1990s and 2000s – available inventory (or a wide selection) is the life force of any used car business (on average a customer buying a used car will spend four to five times as long examining models/brands than a customer buying a new car) without inventory your customer would walk (whereas when buying a new car they would be willing to wait several weeks/months for the color/model they desired).

To understand why leasing was a smashing success in the US, we need to understand how the terms of a lease are calculated (this is just for review, so skip down to next paragraph if you want) – unlike taking out a bank loan to finance the entire value of a vehicle, a lease allows the consumer to finance only a portion of the car’s value, at a fixed rate, over a 36 month period. The manufacturer (not the dealer) calculates this portion by subtracted the specific car’s price by the residual (or, the expected value of the car at the end of the 36 month leasing period). For example, if you lease a $35,000 luxury car for 36 months and it has a residual value of 70%, it is worth $24,500 at the end of the lease. It has only lost $10,500 of its value, and you will have paid $291 a month (plus interest, tax and related fees). As a rule of thumb, monthly lease payments were about 30% to 40% lower than monthly payment resulting from an automotive loan from a bank – naturally, lower monthly payments was a major driver in accelerating the popularity of leasing.

Leasing, for a while, brought a relative clam to the auto industry (all was cool in skool) – OEMs were selling heaps of new cars, dealers were making money, and anyone who could afford a marginal down payment could own (lease) a car – yet, this was no more than a façade, structurally speaking the industry was a mess – and about to getting a whole lot messier.

Thanks to new fangled leasing regimes, more and more new cars were being sold than ever before – and, not surprisingly, competition amongst automotive OEMs mirrored this growth – resulting in lower and lower MSRP – in short, OEMs were sacrificing long-term profitability for short-term gains. Rather than touch the sticker price, manufacturers increased residuals, and thus reducing a consumer’s monthly auto payments. Yet, in order to increase residuals, manufacturers had to assume the car would hold a higher resale value at the end of the lease term. And there inlayed the problem – higher post-lease resale valuations all but ensured a glut in supply as consumers had zero incentive to purchase a three year old car that would cost them seemingly more that leasing a new car.

But what had become an awful situation for manufacturers was a dream for dealers, especially new car dealers. Before we move on it is important to note that during this period automotive auction houses, such as Manheim Auctions and Kruse International (which was eventually bought by Ebay in 1999), experienced dramatic growth (in profits and popularity) – thanks in large part to the surplus in previously owned leased cars. Manufacturers needed an outlet to sell their inventory of leased cars – and as they could not directly pawn the cars off on their established sales channels (new car dealerships) they hooked up with auction houses – the caveat being, that only authorized new car dealers could attend these auctions.

By engaging auctions, manufacturers set in motion events which ushered in the greatest vehicle yard sale of the twentieth century. And what is more, these previously leased cars usually sold for US$4,000 to US$5,000 below the manufacturer’s valuation estimates (to put some spin on this, American automotive OEMs’ profit margins on new cars were already in the red, even before the car hit the auction podium). And, to add insult to injury, a vast majority of these cars were still covered under manufacturer’s warranty, and thus buyers (dealers) effectively transferred any possible risk (defect, etc) to the manufacturers (dealers were given a free put option). Essentially, this lease-auction relationship gave dealers a reliable (semi-exclusive) source of quality (relatively inexpensive) inventory – and keep in mind, consumers had no way of knowing how much dealers paid for these cars – needless to say margins were, well, impressive.

I think it’s now crystal clear the role OEMs played in this saga, but what we haven’t touched upon is the role American rental car agencies, such as Avis and Budget, played. Put simply, these guys at the rental agencies were either leasing away like crazy or purchasing car directly from a manufacturer at just about cost – so, after a year or so, where do you think these agencies dumped their inventory – three guesses but you’ll only need one – auctions. Yup. More inventory. More competition. More price pressure. Just more of everything…supersize me, will yah?

Eventually, manufactures realized they had to put an end to this blood letting and introduced zero percent financing, but by then the damage had been done.

You’ll notice that certification (the Kansas City Shuffle) never once came up in this conversation – the reason is simple – dealers never fell for the certification trap (i.e. a manufacturer charged the dealer between US$300 to US$800 to certify a car) – as we’ve already mentioned above, a majority of the car purchased at auctions still fell under the manufacturer’s warranty – and yet, consumers did fall for the certification trap, refusing (or rather strongly preferring) to purchase a used car from anywhere other than a dealer selling “manufacturer certified” used cars. On average, dealers certified less than 10% of their used cars, and those that were certified were either getting delivered a customer across country or sat on the lot so the dealer could point to a couple cars and say, “yeah, we sell certified cars…”

Given what we know of China’s automotive industry and financial infrastructure – do you think the used car business is primed to explode or do we have a couple more years of pump priming before the market (and inventory) is deep enough to support single (multiple) player(s) offline? Let’s hold-off answering this question for now…however…I don’t think it is unreasonable to assume that, at this point, a viable online entity focused on the used car related market is anything more than a happy fantasy…

(Acknowledgment: I know this isn’t book but I need to send a shout-out to my dad for adding some color to this blog – valuable insights gained by being a leading figure in the US automotive industry since the late 1960s. )

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