US Recovery ... Not Autos: At a bottom (?) but...

Here are updated versions of graphs at the bottom of the blog. For the moment job losses have stopped rising (but haven't fallen much); ditto for unemployment. Participation rates remain low. Discouraged workers and workers on short hours numerous. The number of people unemployed less than 5 weeks is falling, but the number of long-term unemployed (27+ weeks = 6+ months) has yet to clearly do so and remains at the highest level since 1948, when "modern" unemployment data collection began. Motor vehicle sales so far this year remain below 11 mil units SAAR (seasonally adjusted annual rate) vs a bubble peak of 17+ mil. New housing starts ... ouch. And all the jobs that these two industries bring, up and down the value chain and in expenditures in local communities. Banks are only starting to deal with commercial real estate losses. And only in June will the full magnitude of the loss in revenues at the state and local level start to hit home, as tens of thousands of teachers lose their jobs.

Surely it would be better to run bigger deficits today but have educated workers down the road -- the cost/benefit calculation is pretty robust. And surely too people would rather pay slightly higher taxes down the road to regain employment a year or two more quickly. But Congress doesn't see it that way, I guess they can't be bothered with the jobless -- and state and local governments can't borrow so it has to be done at the national level. Nor will tax cuts work -- they're not effective if businesses aren't making a profit and can't borrow to expand. Or if, given the lack of growth prospects, they're afraid to expand.

Now at some future point budget orthodoxy is appropriate, indeed necessary. But just look at Japan to see how long recovery can take if you've come out of a leveraged real estate bubble and refuse to spend -- 12 years. Monetary policy doesn't work, and that's what got them (and us) into trouble in the first place. And extended stagnation builds up debt like mad, the claims that "we can't afford more debt" look hollow when the end result is just that, magnified several times over.

Unfortunately the Bank of Japan was no help. Ditto the US Fed today. After all, you become a monetary economist because you believe money is important, and the Fed (appropriately) employs monetary economists. Bernanke is one such. The models they employ -- DSGE models -- have to remain fairly simple to be tractable, and the base assumptions preclude fiscal policy from being effective. Again, maybe not a bad choice if what you want to examine is monetary policy. But most of the macroeconomic profession has been captured by these models. Plus central banks reign supreme -- again ironic, given their hand in keeping the Japanese and now US bubbles going, and the obvious impotence of a renewed bout of easy money to get the pump going. They need to study technology a bit, to see that you first have to prime the pump.

Autos are less and less similar to what they were in the 1930s; priming? -- there's no carburetor! But our economy looks more and more similar to that of the 1930s. And for all the talk of the New Deal, FDR didn't do much to get the pump going, until the winds of war blew from east and then west. I'd rather we spend on roads and schools than repeat history with tanks and mass mobilization.

Mike Smitka, March 14, 2010

The Cost of Toyota's Problems

Toyota's problems have already proven costly; how large that total will be remains unclear. I provide a couple numbers here, and then note the intangibles that I can't even guesstimate. In addition, I point out that Toyota's problems may prove costly for the industry as a whole, not just for Toyota itself.
First, Toyota has noted that the direct cost of recalls is likely to come to $2 billion. Now a well-run recall program can improve customer loyalty, particularly if it is a voluntary recall. The current ones aren't, but dealerships can clearly be told "treat the customer well" and in fact have been given cash up front to do so. In any case, this is not a cheap problem.
But that's if Toyota's problems were merely limited to recalls. Instead it has a product mix out of center with the market (e.g., it's often on-idle assembly plant in Texas), an undue dependence on production inside Japan (fine when it was ¥120 per dollar, but not at ¥90), and poor sales in various markets. (I'll add a more extensive analysis of Toyota's problems shortly, already out in March 2010 issue of The Oriental Economist.)
Second, and the biggest loss to date, is the drop in market valuation. The peak was in February 2007, and most of the fall occurred before the recall crisis. But the decline is still from 137.15 to 77.8 at close today, or $93 billion.
Third is the loss born by current customers who have seen the resale value decline. Initial reports suggest this might be about $5 billion at $1,000 per x 50 million vehicles in EU and US. Now the decline can end up rather lower, but does this does suggest an amount in the billions.  
Fourth are lawsuits. This is an even rougher guesstimate, but with Toyota's deep pockets, every ambulance chaser is in the race. And there are a lot of accidents. Now how many are tied to defects? -- precious few. Even the California accident that touched off the whole brouhaha may turn out to have other causes -- why didn't he shift to neutral given plenty of time to stop panicking, will the brakes there show overheating, and so on. My hunch is there will be no evidence that would make an engineer suspect a defect. The issue however is what a jury will think. Lots and lots of accidents can be blamed on unintended acceleration. It may be that all of them are due to the driver's behavior. In the US there are counties (in)famous in the industry for courts that have always ruled in favor of accident victims. So $2 billion? -- I fear that's safe. [On 10 Mar 2010 AP Miami reported $3 as more likely.] I have no idea how to consider suits from shareholders and owners of vehicles; I don't know if there is much precedent to suggest that they are likely to lead to payoffs, uh, settlements by Toyota or if they merely garner publicity for a few litigation operations.
Fifth are lost sales: up front, from Toyota, those will come to 100,000 units. At $30,000 per on retail, given Toyota's attempt to move towards the rich end of the product spectrum, that's $3 billion. But that has a smaller impact on the bottom line. However, it hurts when it is prospective customers who are lost. Early reports (TrueCar.com) suggest that shopping behavior changed markedly. Those who do look at Fords and GMs will be pleasantly surprised by what they find. Not good for Toyota.
Sixth are discounts: heavy! Toyota is laying on extended-term 0% financing. Not the deal it might seem with interest rates low, but still a discount as long as you negotiate price first and financing afterwards. Ditto leases – of course there are the "money cost" and depreciation components that permit leases to underprice other options, and the $179-$199 per month are not bad if you don't overpay for the car. So let's say this all runs Toyota $1,000 a car on average over the next year. That's $1 billion. Chump change? – only if they don't stay on and increase. Given Toyota's excess capacity, that seems to me a strong possibility.
Now all this seem might like good news for everyone else. Don't bet on it. This is not the time when the industry wants to see yet more price pressure.
But I'm worried more about unintended acceleration. This strikes me as legal quicksand (or rather, a legal goldmine to litigators). No car company is without some level of NHTSA complaints. Disproving it after the fact is very hard, little physical evidence remains. Sure, filings correlate strongly with the age of the driver – and then there is the US diabetes epidemic, which in advanced stages damages the nerves in feet. Even if that proves less lucrative to the legal profession than asbestos, it will remain a constant headache.
So the cost is added safety regulation. Some of it is not an issue for particular companies, that have a software "brake override" of the accelerator already in their vehicles. It's hard to see what other directions legislation might take, but it might well include additional reporting requirements. If this lets manufacturers bolster the case that their vehicles are safe, everyone benefits. However most accidents remain that – the unfortunate outcome of chance events amplified in most cases by human error. Having more unexplained incidents in NHTSA's database could backfire by suggesting that all vehicles have life-threatening defects – with enough data, you can uncover a pattern even if there is no underlying issue. The industry may well find out which effect dominates, given the ability of the US legal system to provide large settlements to the victims of sufficiently horrendous accidents. I fear for the worst.

Mike Smitka

The Internet and Dealership Fixed Ops

"Pre-owned sales should be driven by a high rate of inventory turn rather than being based on gross profit per retail transaction," says Dale Pollak, CEO of vAuto and the author of the hot selling book “Velocity, From the Front Line to the Bottom Line.” Pollak conducted sold out workshops at the NADA convention this year. The vAuto booth was packed every time I tried to get near it. Pollak’s “velocity” concept is based on the fact that the Internet has changed the way people shop for pre-owned vehicles. When doing an online search, consumers get to a point when they are looking at too many vehicles for them to conveniently digest. They will then select a sorting parameter and in the vast majority of situations they select “Sort Lowest Price First.” Anyone who has ever purchased a pre-owned vehicle online, used Priceline.com, Hotels.com, or the search and sort feature on most online shopping sites knows this process. Pollak maintains, as do his advocates, that it is essential to make sure one’s inventory is priced in such a way as to show up in the first pages of the search, if not the first page. If a unit is priced substantially higher than the lowest priced vehicle of its type, consumers will probably never see it in a multi-page search hierarchy. The monitor of the consumers’ computer is the dealer’s display lot in this new internet driven era. If dealers and their inventory do not show up well on the web they will never see the consumer at their physical location. With dealers in the position of having to compete against their competition in an online scenario, downward pressure has been placed on transactional gross profit. It is truly the market at work and this new trend doesn’t favor auto dealers' traditional business model.

Dealers who use available technology like Pollak's vAuto will gauge their own pricing against their competitors before arriving at a posting price for their own inventory. They have found they can more than make up for the lost gross profit per unit by achieving a high turn rate. This practice also increases the number of F&I “turns” and trade ins taken. Practitioners of the “velocity” model experience astounding inventory turn rates and more than make up for the lower average gross profit per vehicle with overall departmental gross and net profit.

But this column is not about Dale Pollak or vAuto. Their theories are being proven every day in the market place. Dealers who aren’t on board with the theory are getting their butts kicked every day by those who are. This column has to do with the fact that since the pre-owned business is no longer based on a "cost plus" model and is driven by the fact that online traffic on inventory is generated based on pricing that will maximize the number of “hits”, there is a new reality in how dealers charge themselves for internal reconditioning.

In the late 1970’s, state and federal law mandated that auto manufacturers compensate dealers based on their retail customer pay rate for warranty work. Dealers, including myself, rushed to increase their “door rate” to capitalize. It was thought that discounted “menu pricing” would prevent consumers from fleeing to lower priced independents. We can look back with the clear vision of retrospect to see what happened. The increase in warranty reimbursement more than offset any loss of customer pay revenue in the beginning. Fixed Ops became the cash cow of the dealerships. But over time, new vehicles were built to increasingly higher standards and the warranty reimbursement vehicle dropped, along with the recent drop in total volume of new vehicles. Pricing cover was created for the proliferation of independent competitors in both the parts and service space.

At about the same time, it also became popular for dealerships to charge themselves internal rates for pre-owned inventory based on their new higher retail door rate. Instead of using the warranty compensation time schedule, they used full retail for both parts and labor. Previously, most dealers used an internal formula based on what they might provide any other large volume customer, like perhaps a fleet or municipality customer. Labor based in the range of 67% of retail rate and cost plus 25% on parts was typical. Not only were many dealers charging themselves additional mark up with the hopes of retaining at least that amount when the vehicle was sold, but many vehicle departments were forced to do everything “in house.” I’ll leave it to the reader to decide whether or not the retail recon concept has worked out overall. It certainly doesn’t make sense to do internal work at “cost.” It makes no sense to send work outside the dealership if the job can be done competitively “in house.” It is obviously a question of balance, and the debate is over where the balance point lies.

The “retail recon” theory was predicated on that premise that sales people and their managers sell from cost. This premise assumed that a “little extra cost” didn’t make much difference and that consumers would pay based on what the sales staff had the guts to charge and lenders would finance accordingly. The Internet has turned pre-owned vehicles into commodities. Dealers who post uncompetitive asking prices based on their old “cost plus” theories will find themselves on the back pages of the consumers’ Internet search and generate a fraction of the inventory “hits” as their “velocity” competitors. And in today’s environment, getting lenders to advance financing based on what is convenient for the dealer is problematic at best.

The policy put many used car managers in the position of having to recondition based on uncompetitive pricing. As an example, I’ve seen dealers force their pre-owned departments to buy tires at retail from their own parts departments when the same tires were available at half the price from Costco or Sam's Club. Some dealers went as far as to ban the touch up specialists and the “dent doctors,” requiring the work to be done in the body shop. Even sublet tickets have been marked up.
Many used vehicle managers used counter productive methods to deal with some of the impact of the “retail recon” policy on the wholesale side. Some would attempt to “steal" fresh trades to “package” with over age and over the market units to hide losses exacerbated by the extra internal profit that had been penciled onto their inventory. Wholesale buyers didn’t care how much money a dealership had in a unit, it was worth what current market dictated. So how do you measure the lost business from standing down from trades and including potentially high gross profit quick turn units in packages to hide losses?

In my own experience I watched a dealer tell his used car manager he could no longer do paint jobs on older “affordable” price category vehicles with a local MAACO shop. He was forced to do the paint jobs “in house” at a cost $2000. higher than the department had been paying outside. The dealer lived by the adage, “You can’t manage what you can’t measure.” How do you measure what you should have had, could have had, but didn’t get? There were no paint jobs for the dealership’s body shop to do because those vehicles now had to be wholesaled. The dealership lost the 12 – 15 “a month “affordable” price vehicles sales it had previously achieved. “Retail recon” forced other vehicles to be wholesaled instead of reconditioned and retailed. It forced appraisers to look at appraisals in a more conservative way. Fresh sales were lost as well as the trade in and F&I opportunities that would have gone with them. But the internal account on the financial statement looked nice and fat! The service manager got a nice commission check. And the lost opportunities were like they never happened.

Given the current and future pre-owned inventory shortage, many “retailable” vehicles in the “affordable” price category will need to be “made” via reconditioning rather than purchased at wholesale or traded for in near lot ready condition. Will traditional dealers leave those opportunities to competitors whose internal reconditioning structure allows them to “make” these units?

The original “cost plus” theory also included the notion that “fixed op”compensation was generally predicated on a lower percentage than “front end” compensation. "Penciling" gross profit from the sales departments to fixed operations leaves more dollars to fall to the bottom line. Some have mentioned this as one of the factors that has driven more and more sales talent from the auto business.

Will the future bring a more balanced approach to dealer pre-owned reconditioning? If your competitor is a "Velocity Dealer," he or she doesn't want you to change a thing you’re doing!

Written for Wards Dealer Business

David Ruggles is a former dealer-owner, partner, GM, and consultant with 43 years’ experience in the auto industry. He has conducted an annual seminar on auto dealership issues and processes in Japan since 1993, and helped develop specialty software focused on pre-owned leasing. A contributing columnist for Wards Dealer Business and Auto Finance News. Member of the International Motor Press Association. He can be reached at ruggles@msn.com.

Perspectives from NADA Orlando 2010

My first NADA convention was 1987, after the record setting 1986 model year. I recall two things in particular. First, the shrimp and crab claws were of extraordinary size. The shrimp in Orlando this year were particularly puny and the crab claws were conspicuously absent. Second, Maryann Keller’s workshop was so over sold that attendees, including myself, stood down the hall just to hear her words. In my mind, she was and still is the preeminent auto analyst around. I recall her stating that in 1986 Toyota made more money on the investment of its cash portfolio than GM made on its’ entire world wide operations. This was a revelation at the time and began to put the international auto in perspective for me. A lot has happened since 1987.
By my best “seat of the pants guesstimate,” Orlando 2010 was about one third the size of “normal” years. I dread the thought of this being the new normal. NADA artfully arranged things to make the convention seem busier than it actually was. But GM had pulled out of the expo and economics kept many vendors away. As there are thousands fewer dealers after the recent bloodletting, and thousands of others are hanging on for dear life, there were a lot fewer attendees. Those who were in attendance seemed to be in good spirits.
There were some excellent workshops this year. Keller was not there but Dale Pollak, Jim Ziegler, and Joe Verde were standing room only as usual. As a consequence, I chose not to take up space in their workshops as I have seen them before. So I attended workshops by Andrew Iorgulescu from OpenLane, Amanda Savage from Manheim, and Lee Harkins from M5 Management.
Iorgulesco and Savage both commented on the fact that the premium units in terms of mileage and color are increasingly being sold “upstream” and never see the brick and mortar auction. As a consequence, the physical auctions are seeing a higher percentage of “dregs” in their consignments. There is a new generation operating dealerships these days. This generation has never known life without television, computers, video games, and cell phones. They are much more likely to be using the Internet to buy inventory than those my age. I expect the trend to increase.
Lee Harkins blew me away with his comprehensive and insightful presentation on Internet marketing for Fixed Operations. His insight on the new reality of how the Internet drives our business was amazing. Were I still a dealer I would say that attending Harkins’ workshop was many times more valuable than the investment to attend the convention. Kudos to NADA for excellent workshops!
Ed Tonkin took over the chairmanship of NADA for the coming year, taking over from John McEleney. I have known John for about 25 years when I was his competitor in Clinton, Iowa. He is truly a knowledgeable and honorable man. What a year to have been NADA chairman. I’m sure he has had his detractors over the last months, but it is easy to be a Monday morning quarterback. NADA wasn’t in a great bargaining position when things “hit the fan.” I expect incoming chairman Ed Tonkin to be more of a “fire breather” if he is anything like his father Ron, NADA chairman from 1989. Dealers need a tough and aggressive advocate! Tonkin inherits an interesting situation. Terminated dealers are no longer NADA members if they no longer have a new vehicle franchise. Yet, they may be embroiled in the reinstatement process through arbitration. A reinstated dealer might compete with a dealer who was not terminated. This puts NADA and Mr. Tonkin in a tough position.
In the meantime, GM CEO Ed Whitacre seemingly embraces the thought of reinstating as many as a thousand dealers. But Steve Girsky, perceived by many as being the father of the dealer terminations when he was a member of the government auto task force, has just been named to the GM board of directors. It will be interesting to see how this all works out.
DealerTrack and RouteOne had great parties. But there was nary a crab claw in sight.

Written for Auto Finance News

David Ruggles is a former dealer-owner and consultant with nearly 40 years’ experience in the auto industry. He has conducted an annual seminar on auto dealership issues and processes in Japan since 1993, and helped develop specialty software focused on pre-owned leasing. A contributing columnist for Wards Dealer Business and Auto Finance News. Member of the International Motor Press Association. He can be reached at ruggles@msn.com.

Rewriting the Rules

There have been numerous recent quotes from industry experts that some might find contradictory. The issue: How many dealers are needed to maximize OEM profits?
Let’s put this in historical perspective. Back in the day, OEMs felt that boosting the number of dealers and loading them up with inventory would provide maximum market penetration, volume, and OEM profits based on economies of scale. “Inventory pressure sells cars” was the OEM mantra, especially in the case of the Detroit manufacturers.
As they pushed to establish more and more sales points, the OEMs also instituted a strategy to transfer as many of their own distribution and marketing costs on to those dealers, making each a profit center before they sold a single new vehicle. Any dealer who has ever perused the dealership’s monthly parts statement will have a strong opinion on this issue. Savvy dealers learned to survive over-dealering by fighting to keep expenses as low as possible. They maximized the use of facilities, minimized slow-moving inventory, adopted other franchises, and focused on pre-owned vehicles, parts, and service.
OEMs charged and over-charged their dealers for every little thing, including the cost of the Dealer Communication System. They charged for special parts inventory and tools for each new model, marketing costs, brochure racks, bathroom labels, and collateral materials. It is hard to imagine a dealer representing a net cost to the OEM. Add in parts sold to maintain and repair units in operation, and each sales and service point was certainly a profit center.
Then came the Senate hearings, with testimony from then-President Jim Press of Chrysler and then-Chief Executive Fritz Henderson of General Motors. The pair complained about the overwhelming burden they were carrying in having to maintain “excess” dealers. Most knowledgeable people assumed they were simply saying what they thought the Congressional panel and the Auto Task Force wanted to hear.
Shortly thereafter, the pendulum began to swing in the other direction. Quotes from Mark LaNeve, a recently resigned GM sales executive, indicated a concern for “orphan owners.” He espoused the pain of consumers who no longer had a local dealer to go to for sales and service. Even subsequent comments from Press indicated he probably really didn’t mean what he had said during the hearings.
Then President Barack Obama added to the chaos when he signed a bill he had initially opposed, establishing an arbitration process to allow dealers to apply for reinstatement.
Many terminated dealers are so filled with angst they want nothing to do with reinstatement by the OEM that rejected them.
A dealer friend said to me recently, “Reinstatement? Hell, I’m sending them a thank-you note.” This, in reference to having had Dodge yanked from one of his stores and Chrysler -Jeep pulled from another. These operations had received Five-Star awards and were solidly profitable, with ample cash positions and independent floor planning. He had purchased these franchises in recent years, and his investments were rendered worthless almost overnight. There are many similar stories.
Even recent comments by Ed Whitacre, the new GM CEO, indicate he might welcome the opportunity for arbitration boards to reinstate as many as 1,000 dealers. There seems to be particular interest in keeping some Cadillac dealers, whose ranks had been dramatically thinned. Some states were left with as few as two Cadillac dealers.
It must make logical sense to Whitacre that if dealers are essentially "free," the additional sales points will provide extra opportunities for consumers to buy GM products. After all, how many Ford stores will a Chevy owner drive by to do business with a Chevrolet dealership?
At the same time, Chrysler has been complaining about the arbitration mandate and has even offered up veiled threats of legal action to prevent it. Ford is working on strategies to thin out dealers in metro areas, but making no move to reduce the number of rural dealers.
Now I read that Roger Penske, CEO of United Auto Group, is calling for more Detroit Three dealerships to go. I recently toured Penske’s luxury high line facility in Scottsdale, Ariz. It appeared to me that the objective of this operation was not necessarily to make money, but to create the ultimate auto facility, expenses and profits be damned. It makes sense that someone who has made such an investment would want to have fewer competitors.
Most dealers do not have the resources to build such an edifice, despite the push from the OEMs to do so. Even if they did, most dealers exercise some restraint to keep themselves out of a position where record sales years are required just to break even, a situation Detroit has found itself in recently.
Interestingly, today’s consumers seem to care much less about expensive showy facilities than they once did. Their PC and cell phone are becoming their showroom of choice. This practice is being driven by generations who have never known life without cable TV, cell phones, computers, and video games. There are still traditional buyers out there, but it is increasingly difficult to tell who they are when — and if — they come to the showroom.
Treat the internet buyer like a traditional buyer, and there is no way to earn their business. Worse, an accounting of a perceived bad consumer experience will quickly spread through the myriad of online social networking sites, and the dealer’s reputation with true internet buyers will quickly suffer.
The rules of the business are being re-written. I have more questions than answers. But given the rapidly developing trends and conflicting views of the business by the highest level executives in the business, it’s no wonder a lot of us are confused.

David Ruggles is a former dealer-owner and consultant with nearly 40 years’ experience in the auto industry. He has conducted an annual seminar on auto dealership issues and processes in Japan since 1993, and helped develop specialty software focused on pre-owned leasing. A contributing columnist for Wards Dealer Business and Auto Finance News. A member of the International Motor Press Association. He can be reached at ruggles@msn.com.