2. Lending to Automobile Dealerships
Outlook report reveal that from 1982 to around 1991, sumers. Unlike the beginning of the current economic
new vehicle sales expanded or shrank in correlation to cycle, they can no longer take on more debt. So con-
housing starts and existing home sales. With a predicted sumption can only increase as long as their income
growth rate of 1-1.5% per year, the number of house- grows. On the other hand, corporate America is begin-
holds could grow 14%—by 12 million—in the next 10 ning to feel wage pressures due to a decline in the
years. This correlation would seem to indicate that skilled labor pool, so many professionals are starting to
although the number of vehicles per household has see real wage increases from higher demand. This fact,
begun to taper off from its post-World War II highs, the in conjunction with unprecedented manufacturer incen-
number of vehicles per household still could grow 9% in tives, may help to explain why new vehicle sales are
the next 10 years. However, from 1992 to today, still projected to see their fifth straight year of more than
N.A.D.A. data show that housing starts and existing 15 million units sold in the U.S.
home sales growth surpassed gains made by the auto
industry. This can mean either that cyclical sales swings Inventory levels. Another issue facing auto makers is
of the past have finally flattened to high inventory levels, but this
predictable levels or that consumer IN 1991, OFF -LEASE VEHICLES should start to ease over the next
preference has changed and people few years. Two of the Big Three
no longer feel the need to buy a AMOUNTED TO JUST 3.5% OF have closed plants or announced
new vehicle every few years. THE USED VEHICLE MARKET. that they will close them. A year
ago, there were more than a million
Auto leasing. Automobile leas- BY 1997, OFF -LEASE VEHICLES vehicles of over capacity in North
ing now accounts for more than America; in the next two years, it
EXPANDED TO 7.2%. FURTHER
60% of the average dealership’s should drop to 250,000 units. Most
new vehicle sales. Because the cus- EXPANSION IS EXPECTED BY over capacity, however, is in trucks,
tomer is forced to re-lease or pur- which is a growing segment as evi-
THE END OF 1998.
chase a vehicle at the end of the denced by the popularity of sport
lease, dealers now are better able to utilities.
predict sales volumes. In 1988, the average auto loan was
56 months; this has since fallen to 53 months—a direct Despite unknown volatility in the marketplace,
result of more people leasing their vehicles. This enor- Americans still love their cars. With that said, macro
mous lease market is creating other issues, such as what economic considerations can and should be taken into
to do with all the vehicles coming off-lease and what their account when lending to automobile dealerships, but it
effect is on the used car market. In 1991, off-lease vehi- is as important to understand how the automobile mar-
cles amounted to just 3.5% of the used vehicle market. ket has changed to evolve with this dynamic economy.
By 1997, off-lease vehicles expanded to 7.2%. Further
expansion is expected by the end of 1998. The market for Evolution and Trends
used vehicles in the U.S. still overshadows the new vehi- The automobile industry—manufacturers and deal-
cle market. There are roughly 39 million used vehicles erships alike—is rapidly adjusting to meet consumer
sold in the U.S. each year. However, so many nearly new demands and sustain profitability in this somewhat
vehicles coming back to the market will likely drag down cloudy economy. A dip in a particular product line or
prices of new cars. That could have an adverse impact on market share is sure to bring on customer rebates to
dealer profits, but should prove favorable for the con- prop sales back up to predictable levels. Additionally,
sumer. manufacturer-to-dealer incentives have evolved as a
subsidy to sustain franchise profitability. This is a direct
Percent of disposable income. Americans are spend- result of shrinking margins at both the
ing less of their disposable income on new vehicles. In manufacturer and dealership level.
1997, the percentage of GDP allocated towards the pur- Manufacturers have had to retool
chase of a new vehicle fell to 3.8%, down from the tra- engineering processes, cut costs,
ditional average of around 4.2%. One reason for the and make less money per car to
decline is the high debt rate facing many American con- continue the earnings growth
83
3. Lending to Automobile Dealerships
expected by Wall Street. In turn, dealers are seeing their with a particular relationship. It is apparent that vehicle
profits erode from 12% mark-up to closer to 5% per sales will continue to be a prominent force in the U.S.
new vehicle. They, too, must retool processes and cut economy, but who they are and how they are to be sold
costs to make this strategy work. is the underlying question that will become clearer as the
Dealerships now are faced with economic consolidation trend matures.
Darwinism in this highly competitive market. This is Lenders should realize that this is a dynamic market
evidenced by the shrinkage of new car franchises over facing many risks. As a result, past loans made on bor-
the past two decades. Data from N.A.D.A.’s industry derline deals or lack of prudent credit standards will
outlook report indicate that the number of new vehicle soon come to surface if your borrowers are faced with
franchises has dropped from 30,100 in 1972 to just over many of the issues discussed above. Despite a healthy
19,500 in 1998. This consolidation trend indicates that economy and a high profile industry, the car business is
fewer dealerships are actually selling more vehicles. going through some changes.
Unprofitable or ill-equipped dealerships are giving Their industry focus has historically helped dedicat-
way to those better suited to oper- ed auto-finance companies to be
ate in today’s environment. Stand- DEALERSHIPS NOW ARE better equipped to understand these
alone or small franchise dealer- issues. However, the banking
FACED WITH ECONOMIC
ships are facing enormous pres- industry still represents a signifi-
sures from larger mega-dealers able D A R W I N I S M I N T H I S H I G H L Y cant portion of lenders in the auto-
to undercut prices due to motive segment and, as a result,
economies of scale. Depending on C O M P E T I T I V E M A R K E T. must be able to comprehend this
the market, it may just be a matter T H I S I S E V I D E N C E D BY T H E information in order to make sound
of time before outside forces push credit decisions going forward.
a dealer into dissolving the fran- S H R I N K A G E O F N E W CAR Lenders who have not been
chise or becoming acquired by a F R A N C H I S E S O V E R T H E PAST
through a downturn in the economy
large dealer group. For example, may not have exercised prudent
how can a small dealer with one or T W O D E C A D E S. lending techniques when structur-
two franchises that generate annual ing loans. In this highly competi-
revenues of $25 million to $50 mil- tive environment, it is important to
lion compete with the likes of Republic Industries, Inc. understand how a dealership or dealer group fits into the
whose 211 dealerships and 296 franchises posted rev- overall equation of the industry. This will assist a lender
enues exceeding $5.49 billion in 1997? in structuring the financing request according to the
According to a survey taken by Ward’s Dealer risks associated with a particular transaction.
Business magazine in its September 1998 issue, dealers Commercial lending today has become more of an art
are frightened of the cloudy future that lies ahead. than a science because of the enormous amount of variables
Larger dealer groups, such as Republic Industries, Inc., that go into putting a deal together. Loan structure, prof-
are quickly penetrating major metropolitan market seg- itability, balance sheet ratios, geographic location, product
ments and mid-size cities with clusters of same-brand lines, ownership and management experience, as well as the
dealers. This trend, still in its infancy, is beginning to guarantor’s secondary financial support, are just a few of
take its effect on the profit and loss statement for many the items that go into determining the viability of lending to
smaller dealers. According to the survey, many dealers automobile dealers.
felt that the one obvious solution for dealer survival in Credit Risks Associated with Dealerships
this era of consolidation, aside from selling out, is to Mega and public dealers. Diversification and
pool together to remain competitive. What that means, economies of scale are positive attributes for larger deal-
however, no one is sure. er groups, however, credit risk is greater due to high dol-
lar exposure, concentration issues, and the sheer com-
Lending Issues plexity of dealing with multiple entities. Credit facilities
Understanding the changes in the automotive sector can also take on many forms. Many large dealer groups
and how it is and will continue to affect dealerships will are opting to forgo traditional floor plan lending for larg-
better prepare a lender for the various risks associated er credit lines utilized for numerous business needs such
84 The Journal of Lending & Credit Risk Management December 1998
4. Lending to Automobile Dealerships
as inventory financing, working capital, and acquisition entity under a holding company? Does each dealer-
capital. These types of credit facilities require careful ship stand on its own in terms of cash or is there a
structuring in terms of financial covenants at the group sweep account utilized? How are earnings treat-
and individual dealership level, limitation on usage of ed—left in the store or paid out in management
funds, loan-to-value guidelines, and specific criteria fees? Again, these questions will help the lender
regarding the acquisition of dealers. understand how cash is flowing through the system
To better understand these larger dealers and their and provide a comfort level on how business is
associated capital requirements, a lender should meet being conducted.
the key players to get a sense of overall business strate-
gy and raise some high-level questions, such as: • How does this dealer group differentiate itself from
others? Many large mega dealers essentially focus
• How many and what type of franchises? This is on similar strategies that involve certain regional
important in determining the dealer group’s partic- focus, but the varying factors usually include how
ular dependency upon domes- management and personnel issues
tics or imports and, more LOAN STRUCTURE, PROFITABILITY, are handled or how acquisitions are
specifically, upon franchises structured. If it’s a public dealer
that may be experiencing some BALANCE SHEET RATIOS, group, determine whether there are
problems in the marketplace. GEOGRAPHIC LOCATION , PRODUCT
stock options given to the previous
owner and any time restrictions. Is
• What is the current and/or LINES, OWNERSHIP AND the same crew continuing to oper-
planned geographic structure? ate the dealership or will new per-
MANAGEMENT EXPERIENCE, AS
This will assist a lender in sonnel be hired? This is important
understanding the dealer WELL AS THE GUARANTOR ’S because many dealer principals
group’s economic exposure in have simply cashed out but remain
SECONDARY FINANCIAL SUPPORT,
specific regions, its underlying in the store. As such, motivation to
customer base, and competi- ARE JUST A FEW OF THE ITEMS operate successfully can deteriorate
tive pressures. if the right incentives are not
THAT GO INTO DETERMINING THE
implemented. Also, what is the
• What type of management and VIABILITY OF LENDING TO AUTO- group’s purchase policy/formula
financial controls are in place? for acquiring additional dealers?
MOBILE DEALERS.
The key here is to determine Many groups, quick to keep pace
whether the group is managed with other industry giants, can and
from a centralized, regional, or individual dealer- have paid too much. This can cause some capital-
ship level. As groups become larger, it becomes cru- ization issues and degrade the balance sheet if over-
cial for the lender to implement controls that can looked.
quickly identify internal weaknesses, determine Keep in mind that these simply are high-level ques-
capital requirements, and manage cash flow. Cash tions that should be addressed prior to going into all the
flow is especially important due to the high sales due diligence that’s necessary in making a sound credit
volume and low margin strategy utilized to remain decision.
competitive and retain customers. Reporting con-
trols are key in maintaining financial consistency Small dealers. Small mom & pop dealerships,
and accuracy of bookkeeping. And management depending on their operating performance, product
controls should be in place to maintain focus and lines, and competitive market pressures, can offer a bet-
accountability at each dealership, as well as compe- ter return while minimizing dollar exposure. However,
tency of management at the executive level. understanding the following issues is
paramount in making a
• How does the business operate? The point of this sound lending decision.
question is to understand the organizational struc-
ture. For example, is each dealership a separate • Smaller dealers have credibility
85
5. Lending to Automobile Dealerships
simply because they’ve been in business for a long considered because many long-time small dealer-
time, are socially committed to the local communi- ship owners are at retirement age. Hopefully, family
ty, and have a demonstrated track record of prof- members who have been working in various capaci-
itability. This, however, does not ensure continual ties at the dealership are prepared to take over, but
success. Similar questions to those for mega dealers this may not always be the case. This is also anoth-
should be raised, but smaller dealerships need fur- er reason for a large number of dealers selling out
ther consideration. Added emphasis must be placed to larger groups.
on small dealers’ operating efficiencies and fixed
operations in light of their uncertain futures from Conclusion
consolidation price pressures, eroding margins on Considering the magnitude of this industry and the
new vehicles, and the negative effect of off-lease rapid changes its undergoing, good lenders must contin-
vehicles on margins in what was once considered ually educate themselves in many capacities.
one of the dealer’s more prof- Understanding car dealers is just
itable departments. one component. The lender must
SMALL MOM & POP be aware of what’s going on with
• As margins decline to sustain the manufactures, auto auctions, as
DEALERSHIPS, DEPENDING
sales volume, smaller dealers well as consumer debt related to
with above-average fixed costs ON THEIR OPERATING the auto business. This is a large
will begin to see their break- cycle that is all interconnected.
PERFORMANCE , PRODUCT
even point pushed up further. Comprehending the macro
Having strong absorption from LINES , A N D COMPETITIVE economics of the industry is just
fixed operations, which is very half the battle. Above all, the
important in offsetting expo- M A R K E T P R E S S U R E S, C A N lender needs to have a solid
sure to sales fluctuations, is OFFER A BETTER RETURN understanding of the type of deal-
one of the more important ership and how it conducts busi-
ingredients in sustaining suc- WHILE MINIMIZING ness. Lending to automobile deal-
cessful operations for a small D O L L A R E X P O S U R E.
erships can be both risky and
dealer. Many customers still rewarding, so the lender is advised
prefer the personal attention to maintain prudent credit stan-
from a smaller dealer when it comes to servicing dards and price accordingly. This will prove beneficial
their vehicle. However, much of this back-end busi- in the long run.
ness is correlated to customer retention and sales
growth on the front end of the business. If competi- References
tive pressures begin to depress front-end sales
Industry Outlook Report, N.A.D.A., September 1998.
growth, service and parts business will usually
decline over time. Ward’s Dealer Business, September 1998.
• As noted above, operating efficiencies are crucial
for smaller dealers. Because the span of control
requires less personnel, smaller dealerships should
have an active dealer principal who plays many
roles. This will alleviate the need for unwarranted
management levels and the extra overhead. While
smaller dealers must consider many other items,
keeping costs down in this low-margin era will
become even more important in sustaining prof-
itability.
• Additionally, succession plan issues also need to be
86 The Journal of Lending & Credit Risk Management December 1998
