Self Inflicted Abuse
In the fall of 2015 we released a video study entitled: "The Coming Global Auto Abyss - Too
Much Supply, Too Many Brands; Combine with Too Much Credit!". We
concluded that low interest rate monetary policy for the auto industry
was like handing crack cocaine to a drug addict. The auto industry would
rapidly and irresponsibly abuse it, to such an extent that it would once
again 'spin out' and careen back to what can only be termed
the Washington 'substance abuse center'. Whether mis-management or
clever strategy we are unfortunately being proven right and are now
witnessing the reality.
The Washington Keynesian planners mistakenly believe that cheap money
still stimulates demand. It historically did this before it became a legally
addicting substance, but even its original tenet was
essentially based on bringing demand forward. By design this
creates a demand hole in the future, but as Keynes himself famously
rationalized: "in the long term we are all dead" ... so not to
worry when the economic need is urgent! Setting aside for a moment this
critical structural reality, we need to remember that cheap credit
additionally fosters structural ramifications seldom elucidated:
- EXCESS SUPPLY: Cheap and readily available credit
creates excess supply as manufacturer have their capital costs reduced
allowing them to competitively pursue market share in the wanton beliefs
they can gain competitive advantage due to increased volumes, buyer
financing, supply chain leverage, aggressive advertising etc.,
- INDUSTRY CULTURE: Sustained periods of cheap credit unintentionally
changes buying behavior patterns, expectations and financing
structures of industries.
Ford Inadvertently Signals the Reality
During Ford Motor company's latest earnings call, while defensively
attempting to justify a massive 50% shortfall in earnings (falling to
$0.30-0.35 from $0.68 in Q1 2016 and versus expectations of $0.48), they
disclosed that sales volumes are now expected to fall off this year and
next with used car prices dropping for several years!
How could this be with US industry sales at historic levels approaching
18M units per year and no one anywhere with any credibility, even remotely
suggesting that a US recession was imminent? The answer is that 'hole' we
referred to above has arrived but it is a much worse chasm because of the
industry financing options that have been foisted on the unsuspecting,
tapped out US buyers since the "cash-for-clunkers" slight of hand.
The industry has created a minimally two year hole in the market that
will flood used and new auto supply inventories while buyers are
effectively locked out!
This is not how a well managed industry strategically and responsibly
plans, unless of course the game is actually government regulatory arbitrage
(think: "Cash-for-Safety" to justify new expensive regulatory features)?
How It Was Orchestrated - Give Buyers Only Two Choices
Auto Leasing has exploded since 2015 and now approaches 35% of
all sales. The Lease terms are normally 2-3 years with questionable residuals
being used to achieve low lease rates on highly priced units. We have now
entered the period where those initially leased units are being returned - in
massive. Meanwhile, those Buying versus Leasing have been financing over much
longer terms. Ford detailed this with the following charts for their units sold.
The Ford Motor Earnings Presentation
Vehicles prices since 2008 are dramatically higher. A $28,000 vehicle in
2008 is now $50-$55,000 and loaded down with new standard equipment features
such as backup cameras, WIFI, Seat Warmers etc to justify the higher prices.
Prices that can only be sold via cheap credit financing terms. It was to be
an expected marketing strategy to drive profits higher while money was cheap.
As a result:
- Vehicle Purchases were financed out over periods that
bordered on the useful life of the vehicle (based on non- warranted
maintenance costs),
- Vehicles were increasingly leased on 2-3 year leases
with high residual values and mileage limitations.
The government wanted it, the central bankers wanted it and the industry
wanted it. To achieve this it meant a sustained period of cheap money and
creative financing. But it comes with a price tag that must soon be paid! All
of this is now hitting as Ford inadvertently warned!
The Coming Chasm in Auto Demand Is 'Baked-In'
Consider The Following 7 Industry Facts
- Historic sales Levels: Motor vehicle sales have
boomed in the years since the Great Recession.
- 2016: U.S. sales of new cars and trucks hit a record
annual high of 17.55 million units.
- 2017: J.D.POWER / LMC AUTOMOTIVE: Industry consultants
J.D. Power and LMC Automotive reiterated their forecast for a 0.2
percent increase in sales in 2017 to 17.6 million vehicles.
- 2017: MOODYS: Moody's on the other hand says it expects
U.S. new vehicle sales to decline slightly to 17.4 million units in
2017.
- 2017: EDMUNDS: For the full year, Edmund says sales
appear to be falling short of last year’s record of 17.55 million
vehicles. Edmunds is looking for a 2017 total of 17.2 million vehicles
amid softer consumer demand for both cars and utilities as the year
progresses.
- Peak Auto Sales: Moody's Investors Service said
in a report that U.S. auto sales have peaked, competition to finance car
loans is set to intensify and drive increased credit risk for auto
lenders.
- Trade-In Treadmill: Typically, car dealers
tack on an amount equal to the negative equity to a loan for the
consumers' next vehicle. To keep the monthly payments stable, the new
credit is for a greater length of time. Over the course of multiple
trade-ins, negative equity accumulates.
- Lenders = >Terms: Lenders have supported
automotive credit growth with "accommodating financing,"
including longer loan terms, Lenders could further lower annual
percentage rates and keep extending loan terms, though the latter would
increase their credit risk.
- Manufacturers=>Incentives: To ease consumers'
monthly payments, auto manufacturers are subsidizing lenders or
increasing incentives to reduce purchase prices, though either action
would reduce their profits.
- Lending Credit Risk: "The combination of
plateauing auto sales, growing negative equity from consumers and
lenders' willingness to offer flexible loan terms is a significant
credit risk for lenders," Jason Grohotolski, a senior credit
officer at Moody's recently told Reuters. In the first nine months of
2016, around 32 percent of U.S. vehicle trade-ins carried outstanding
loans larger than the worth of the cars, a record high, according to the
specialized auto website Edmunds, as cited by Moody's.
- Incentives
- Incentives currently average 10.4% of a new-vehicle’s
MSRP, which is the highest percentage since March 2009 when rebates
averaged 11.3% during the Great Recession.
- SUVs and pickup trucks—with a combined market share of
61.5%—still dominate the sales mix in a market that is bolstered by
rich incentives averaging $3,768 per vehicle, according to a March
sales update from J.D. Power and auto forecasting partner LMC
Automotive.
- Used Car Prices
- A decline in used-car prices is a bad sign for
dealerships, which typically see better returns on used vehicles versus
new ones.
- Limited supplies have driven up prices in recent years,
but analysts have warned that used vehicles would increase in number as
leased vehicles are returned to dealer lots.
- Since 2015, consumers looking for lower monthly
payments have leased new vehicles at a record pace. Many of those cars,
trucks and SUVs that were leased at the start of the recent U.S. sales
boom are now reaching the end of their terms.
- Ally, the former finance arm of General Motors (GM),
noted in a recent presentation that full-year earnings growth would
fall short of expectations, citing the anticipated price drop for used
cars. "We’ve seen a pretty dramatic move in 2016," said Ally
CFO Chris Halmy, adding that the downward trend is expected to
continue.
- The used-vehicle price index from the National
Automobile Dealers Association posted a 3.8% decline in February compared
to the prior month. NADA also said wholesale prices fell 1.6%.
- In the first quarter of 2017, Ally saw used-car values
retreat 7%, a steeper move compared to the company’s projection for a
5% drop in 2017.
- Falling used-car prices are a troubling trend for
manufacturers, dealers and financial services firms, including Ally and
in-house lenders such as Ford (F) Credit. Some bargain hunters will be
swayed by affordable used cars, thus reducing demand for new models.
When sales begin to slow, automakers often ramp up discounts to attract
buyers, a strategy that cuts into profits.
- Incentive spending in March rose 13.5% month-to-month,
hitting $3,443 per vehicle, based on data from ALG, TrueCar’s (TRUE)
research division. Those gains were slightly offset by an increase in
transaction prices.
- Inventories
- Car Inventories Swelled to 13-Year High - highest level
since 2004, a potentially troubling sign for automakers.
- In February, new vehicles waited in dealer inventory
for an average of 74 days before a sale, the most "days to
turn" since the government’s Cash for Clunkers program in 2009.
- Passenger cars accounted for roughly 38% of all new
vehicles sold during the first two months of the year, reflecting a
sharp decline. Sedans have fallen out of favor with many consumers
enticed by roomy and fuel-efficient crossovers. Although manufacturers
have cut production of some small cars, supplies remain at elevated
levels.
- Caldwell noted Banks are stretching out loans to make
payments more affordable for buyers, extending loan terms as high as 84
months.
- The average loan term in February marked an all-time
high at 69.1 months, beating the previous record set in September 2016,
based on Edmunds data.
- For the full year, sales appear to be falling short of
last year’s record of 17.55 million vehicles. Edmunds is looking for a
2017 total of 17.2 million vehicles amid softer consumer demand for
both cars and utilities as the year progresses.
What Will We Do with This Inventory?
There are now approximately 265 million light vehicles registered in the
US today compared to 255 million driving age people, or just over 1 car
eligible driver. How many cars can we absorb, especially since useful age of
vehicles has been increasing by one year every 6.7 years over the last 20
years.
We have a massive problem looming and the auto industry knows it. We are
fully expecting broad based problems to emerge over the next 18 months
in multiple areas of the auto industry:
- The US Dealership Network,
- Auto Manufacturers,
- Lenders & Financiers,
- Securitization (ABS, CLO, Synthetics etc) Investors
This is all as predictable as a drunken sailor on shore leave. We knew
cheap money would be too much for auto executives to refuse and
oversupply was a sure bet! So will be the industries return to the
Washington "substance abuse center". Expect the industry to be back
at the government feeding trough asking for help.