The Perfect Storm
The following topics all have their part in fueling the storm to come:
1) Trade Cycles and How They Affect New Vehicle Sales Velocity
Used car values determine in large the velocity of new car sales. Most new car transactions involve a trade. The level of equity in the trade oftentimes determines whether a new vehicle transaction will be successful or not. Inclining used car values lead to faster trade cycles while declining used car values lead to slower trade cycles. Dismal new car sales volume during our last recession created a shortage of used cars. This created a large supply and demand imbalance that made used car values soar from 2009 till 2014 as seen on this chart.
This time period was extremely favorable for new car sales because consumers found themselves in an equitable position on their vehicles in a very short period of time. To illustrate this, consider this chart of a 60-month loan.
The black line represents the principal balance owed. An optimal trade cycle occurs when the principal balance owed on a loan intersects with the market value of the vehicle. The bullish used car cycle for passenger cars ended in 2014 as a result of extreme pricing pressure from new car leases. Since 2014, used passenger car values have corrected and continue to underperform. This underperformance is largely due to the effects that falling used car values have had on new car sales velocity. A longer trade cycle results in a slower velocity of new car sales. Today, we’ve seen data suggesting that used car values can drop as much as 50% from current levels. Refer to the above loan chart and consider what a drop that large would mean for new car sales velocity in terms of trade cycles.
2) Increased Dependency on Leasing
Used car values also determine the effectiveness of leasing. The most significant component of a lease is the gap between the residual value and the sale price of the vehicle. A residual value is little more than a guess at the future value of a vehicle. Manufacturers and third party companies like ALG use current and historic used car value data to establish residuals. Because of this process, residual values tend to lag used car values. As residuals rise, the gap between the residual value and the sales price gets smaller leading to lower payments. As residuals fall, the gap becomes larger leading to higher payments.
There are many benefits to leasing, but the most important is affordability. Affordability is most often measured in terms of monthly payments. As leases become more affordable, they become more appealing to consumers and penetrate at a higher percentage of total sales. The bullish cycle in used car values from 2009 till 2014 led to some of the lowest lease payments I’ve seen in my career. Consumers noticed and took advantage of the savings.
Residual values lag used car values. When used car values outperform residual values, lessees can trade early and utilize the equity in their lease as a down payment towards a new purchase or lease expanding the new car business. When used car values underperform residual values, new car business contracts as lessees are forced to go the full term of the lease and are left without equity in the end. As I mentioned earlier, used car values for passenger vehicles have been falling significantly since 2014. Aside from the negative effects that used car values underperforming residual values have on new car sales velocity, the lagging effect discussed earlier leaves captive banks open to a considerable amount of residual risk. Please use this link and read through the entire thread for a number of examples using BMW leases.
As used car values continue to decline, residual values will continue to adjust downward. Lower residuals will lead to higher payments, and leasing will produce fewer sales.
Leasing is responsible for a significant portion of total light vehicle retail sales. Here’s a look at the penetration rates by manufacturer.
The average new vehicle price has inflated by 20% since 2008. Leasing has become the best and/or only way for consumers to afford new vehicles while prices continue to rise. This is evident when you see manufacturers relying on leasing for most of their sales volume. What happens to the sales volume for individual car companies and for the auto industry as a whole when residuals are adjusted lower and the affordability that leases provide is lost?
3) Credit Risk
While conventional auto loans only carry default risk, leasing adds residual risk. Leases do not have to default to become a problem; they can become a problem at maturity. Most of the outstanding leases have been securitized bringing us back to 2007 levels. The appetite for auto related ABS makes perfect sense since leases haven’t produced negative equity for years. This adds a layer of complexity that needs to be considered.
The gap between residuals, principle balanced owed for all auto loans and the recovery value for vehicles will grow as used car prices continue to fall. The larger the gap between balances owed and used car vales, the larger the risk and potential losses for the banks holding these loans.
4) What’s Holding It All Up?
The light truck and SUV segment is at a different stage in its’ cycle compared to passenger cars. The majority of US consumers prefer light trucks and SUVs instead of passenger cars. However, the performance of the light truck and SUV segment is very dependent on the price of fuel. Years of low fuel prices have kept the demand for light trucks and SUV very high. So what do you do when one segment (Light Pickups and SUVs) is outperforming the other (Passenger Cars)? Well, you build less of what’s underperforming (Passenger Cars) and more of what’s outperforming (Pickup Trucks and SUVs). Much like a stock market index where money can flow into big names like FANG while market breadth is lost and still move up, manufacturers have shifted their focus toward the more profitable light pickup truck and SUV market. This has experts very focused on oil to gauge the overall health of the automotive sector.
5) Think Fuel Prices Are Your Leading Indicator? Guess Again…
The same thing that caused the correction in used passenger car values is now affecting light pickup trucks and SUVs - ultra low lease payments. Note how lease volume is now favoring SUVs instead of passenger cars. (Residuals are correcting in passenger cars, which translates into higher payments.)
Consumers purchase used cars because they are typically more affordable than new vehicles. Affordability is most often measured in terms of monthly payments. What happens to used car values when a new vehicle becomes more affordable than its’ 1, 2 or 3-year-old version?
6) Supply and Demand
Rate of sale calculations from a record setting year followed by 4 months of year-over-year misses, has left us with a high-day supply of new vehicles.
When sales velocity slows down, the expected reaction from manufacturers is more incentives, and increased incentives are exactly what we received. To illustrate this, let’s take a look at General Motors. GM had a 98-day supply of vehicles at the end March (2017). Ninety-Eight days is very high, but GM stated that it’s part of a strategic build in their inventory. Even if that is the case, the Malibu had a 124-day supply and the Silverado had a 115-day supply. The response to the day-supply problem in Silverado and Malibu was a very aggressive lease and 20% off MSRP respectively.
This scenario triggers a series of events that places a lot of negative pressure on used car values.
This new car problem precedes a supply glut of lease returns. Supply will soon overwhelm demand as the record setting leases of the last 3 years mature. Here is a look at a maturity chart for Ford.
Lease maturities don’t necessarily turn into inventory problems. When used car values are outperforming residual values, most clients elect to buy the vehicle from the captive banks or utilize the equity as a down payment toward a new purchase or lease. A smaller amount of vehicles reaching wholesale auctions limits supply and supports higher used car values. However, when used car values underperform residual values, clients will exercise their right to return the keys to the vehicle and use the protection that the residual value provides. A growing return rate shown here on this slide from Ford’s Q1 earnings call is proof that this is happening today.
Dealers will also reject maturing leases at the residual value thus leaving the transfer of ownership from captive banks to the new owner at wholesale auctions. This will lead to higher auction volumes resulting in lower used car values.
7) The Competition Does Not Wait
Competitors will not sacrifice market share while another manufacturer manages a day-supply problem. As I expected, competitors responded quickly to the aggressive lease on Silverado:
These aggressive leases are exactly what triggered the correction in used passenger cars. Will it be different this time?
8) Manufacturers Start The Problem And Dealers Supercharge It
New car dealerships are being built in vast quantities. With demand slowing, more dealers have to fight for fewer sales. This supercharges the already large discounting effect created by the manufacturers. The unintended collateral damage becomes used car values. What market is left for used cars when new cars are less expensive?
9) 2016 Leftovers in May of 2017
A quick scan using your favorite auto search engine will reveal a staggering amount of new 2016 leftovers. On May 10, 2017, a simple internet search returned 145,763 leftover units nationally.
This is concerning for many reasons. Dealers place very heavy emphasis on getting rid of prior model year vehicles before the end of each year. At a certain time of the year (already past), manufacturers will give dealers a lump-sum payment per unit of unsold prior model year vehicles and remove incentive support in terms of special leases, incentivized rates and rebates. Dealers do not want to have any leftover vehicles when this happens, as those vehicles are extremely difficult to sell against the newest models that have manufacturer incentive support.
The amount of leftover new car inventory is also a sign of slowing demand. These vehicles represent the heaviest discounted portion of new car inventory at dealerships. The 2016 leftover models have not sold yet and we already have 2018 models at a showroom floor near you.
10) How Important is the Health of the Rental Car Market?
The problems facing rental car companies today are very serious. It’s important to understand how their monthly per-unit expense relates to profitability.
There is a direct correlation between used car values and the car rental company’s monthly per-unit fleet cost. The rise in per-unit cost has a direct effect on profit margins. You can see this very clearly if you overlay the NADA used car value index over a stock chart during the same time period.
The monthly per-unit cost at Hertz is currently $348. Consider what happened to sales into rental (below chart) in 2009 with a similar per-unit cost.
11) Expected Results Versus Reality
Many respected sources are projecting flat retail sales for 2017 and a modest 1% decline in 2018. I respectfully disagree. We are simply too far along in a used vehicle value correction that currently includes light pickup trucks and SUVs. Leases will become less affordable as residuals rise. Without leases, we simply will not have the volume needed to meet those projections. I also believe that sales to rental car agencies will significantly decline moving forward. At this pace, the possibility of a major rental car agency going out of business in the next year is not out of the question.
12) Not Simply a Retail Sales Problem
It is not only retail sales that we need to worry about, but also manufacturing - an important part of our economy. A 10% reduction in the automotive SAAR can trigger a nasty set of events. The possibility of losing the affordability of leases, representing a growing number of retail sales, and fewer orders from rental car companies are enough to make a 10% correction a considerable and respected threat.
13) What Comes Next
I have a hypersensitivity to both changes in inventory and catalysts that impact used car values. Stable used car values are an absolute necessity for a healthy new car sales environment. As manufacturers continue to discount new vehicles heavily, they are simultaneously destroying the value of the used vehicle that potential customers need to trade in for the purchase of a new vehicle. The destruction of used car values offsets the effect of heavy discounting, lowers lease offers and pushes trade cycles out further. I view the manufacturers’ day-supply problem as a catalyst for the next leg down in used car values. Take a look at this chart from Morgan Stanley Research.
The first time I saw this, I did not believe that a 50% correction would be possible. I asked myself, Do they know the impact that a 50% correction in used car values would have on the automotive industry and the banks that service the loans?
Well, I stand here today as witness to a perfect storm that could make a 50% reduction in used car values a very real possibility. I have already witnessed signs that the truck and SUV market have corrected. The manufacturer's’ incentive response to a growing day-supply problem along with the supercharged discounting effect of more dealers fighting over fewer sales is the equivalent of dropping the MOAB on used car values. This set of events has made new cars, in some cases, more affordable than used cars.
Used car values will fall as a result but not immediately. Inventory at wholesale auctions will begin to backup as demand from dealers dwindles and sellers unwilling to accept sharp losses reject offers. This can only continue for so long as a tsunami wave of lease returns starts this year (2017) and will provide an unrelenting amount of inventory until the end of 2019. If inventory backs up at auctions, the drop in used car values will be sudden and unexpected, as sellers will have no choice but to unload the vehicles to the highest bidder. The effects will ripple through the entire automotive sector. Trade cycles will be pushed out further, leases will penetrate at lower percentages as residuals adjust, retail sales will slow, dealers will reject inventory, rental car companies will shrink their inventory levels as per-unit cost continues to rise, and ultimately manufacturing will slow or stop for a period of time while the rate of sale is adjusted.
The auto industry desperately needs a YOY beat in retail sales to relieve some of the pricing pressure from a growing day-supply problem. Another miss in May would be a detrimental event that could bring a slowdown or stop to auto manufacturing sooner than expected.