UK Car Dealerships - Lessons from the Last Recession 2009

Ernst & Young

Introduction

The severity of the credit crunch and the speed with which the UK moved into recession in the second half of 2008 resulted in a rapid deterioration in new vehicle registrations and led to heavy discounting, contributing to a slump in used car residual values. This impacted dealer profitability, as evidenced by an increase in insolvencies.

Dealer Insolvencies 2007 versus 2008

 
Furthermore, it was not just small dealers that were being impacted: insolvencies spread from exclusively small operators in 2007 to a combination of small and medium dealerships in 2008 as the downturn worsened. Although the situation for dealerships appeared to have stabilised somewhat in early 2009, we believe that this was only a temporary respite.

The most striking feature of this downturn in comparison to what the industry faced in the early 1990s is that in the lead up to the previous recession, dealers were reporting higher profit levels than they were in 2009. This is demonstrated in the graph below which analyses EBITDA margin for UK franchised dealers over the last 18 years.

EBITDA margin for UK franchise dealers from 1989 to 2007

 
Most significantly, the largest dealers have seen their margin premium eroded since the last recession, leaving them almost as exposed to the effects of the downturn as their smaller rivals. Despite this, we do not expect a fundamental change to the business model for automotive retail. New cars will still predominantly be sold through franchised dealerships; further consolidation among the larger dealer groups is doubtful; and vehicle manufacturers are unlikely to materially increase their ownership of dealerships. However, we think it likely that there are further dealer closures to come. The exact quantum of this is difficult to predict as it is dependent on a number of factors, the most important being the level of support the Original Equipment Manufacturers (OEMs) and banks provide to dealers during the tough times, the brands being represented, and the quality of dealership management.

It is against this continually evolving backdrop that we set out to capture our thoughts on this sector. In this paper, we share our perspective on the current and future trends of dealer profit streams, and highlight what this means for the automotive sector as a whole.

Dealer profit streams

Ignoring ancillary services offered by some dealers, the core revenue generating activities of a franchised dealer are the sale and service of motor vehicles. As a proportion of turnover, although new car sales would normally make up around 50%, their contribution to profitability is less significant.

Illustrative revenue and profit streams

 
The lower than expected dependency on new car sales is part of the reason why the significant decline in volumes in the first half of 2009, a 25% down versus previous year, had a less severe impact on dealers in terms of failures. In addition, most OEMs had reduced volume targets in response to the challenges facing the sector; residual values had recovered during early 2009; and the corresponding recovery in used car profitability also limited the impact of a decline in registrations.

Conversely aftersales, although only typically around 15% of dealer revenues, is often the largest generator of profits with many dealers targeting and delivering over 50% of gross profit from this source. This implies that performance here, rather than in new car sales, is more critical to the general long-term financial health of franchised dealers.

New car sales

2008 saw a significant decline in new car registrations during the second half of the year, resulting in a year-on-year decline of 11.3% to 2.1 million cars. This decline in sales continued into 2009 until the impact of the Government's scrappage scheme provided a much needed boost for the sector. Despite this, the Society of Motor Manufacturers and Traders (SMMT) still predict total registrations for the year to be 1.9 million.

Rolling 12-month new car registrations, March 2008 to June 2009

 
The graph above demonstrates the impact of the scrappage scheme, which was introduced in May 2009 giving retail customers a £2,000 discount against part exchanged (scrapped) used cars over ten years old, made up of a manufacturer incentive matched by the Government.

The impact of this has been encouraging with September 2009 registrations showing an 11.4% increase against September 2008. The main winners have been manufacturers offering smaller and cheaper models, which are more attractive given the fixed cash incentive nature of the scheme resulting in a large percentage discount on the vehicle value. With the scheme 75% utilised by September 2009, the Government announced funding for an additional 100,000 vehicles, only lasting till the end of 2009.

Our view is that it is too early to conclude on whether the impact of the UK scheme was truly incremental, or only brought forward purchases that would have been made in the future. Regardless, its effectiveness was likely to be limited for a number of reasons: not all OEMs were benefiting from the scheme, particularly those at the prestige end; the scheme favoured smaller cars, which are less profitable for dealers to sell and service; the scheme only stimulated private sales, which represent around half of the market; and nearly new vehicle sales were excluded.

By comparison, the German scheme proved more successful, at least in the short term, and led to a substantial rise in volumes in 2009 compared to 2008. A greater proportion of cars in Germany were eligible: their scheme applied to cars over eight years old (versus 10 in the UK); the average age of the car pare in Germany is significantly older than in the UK; and their scheme also applied to the purchase of nearly new cars.

Looking beyond the scrappage scheme, the most promising indicator of recovery in new car registrations is likely to be a return to Gross Domestic Product (GDP) growth. As the graph below demonstrates, a strong relationship exists between annual changes in UK car registrations and GDP.

Ernst & Young point of view Considering we are experiencing the most severe economic downturn for more than 50 years, with recent market peaks driven by the availability of cheap credit, it is difficult to see new car registrations returning to the record levels of 2.6 million reported during 2002-2004 within the next decade.

 
Annual % change in UK GDP and total UK car registrations, 1981 to 2009

 
The early 1990s recession resulted in a greater than 20% decline in new car volumes from 1990 to 1991, supporting the view that new car sales volumes are highly sensitive to the economic cycle. The return to growth in sales was also very sudden, occurring a year after the steep decline, albeit from a lower base. This implies that we are likely to experience a sharp return to growth in the current market, possibly sooner than some commentators expect. However, during the last recessionary period, it was not until five years later that volumes recovered to over two million units, albeit this was with the benefit of a greater availability of credit than is currently being experienced.

Used cars

In response to heavy discounting of new cars and pre-registrations by dealers, coupled with reduced demand for used cars as the downturn started to take effect, used car residual values started to decline sharply in March 2008, and this continued through to the end of the year. This made financing of used car stock more difficult and forced dealers to take write-downs, impacting their profitability and impairing their ability to accept trade-ins as part of any vehicle sale. This also raised the new car purchase cost to buyers, typically dependent on selling their existing vehicle.

However, the decline in residual values experienced during 2008 appears to have recovered and subsequently stabilised during the first few months of 2009, as supported by data provided by British Car Auctions (BCA).

Average UK used car sales price

 
In the space of six months, a problem of over-supply and depressed demand has quickly shifted to one of under-supply, particularly amongst prestige cars, and lower volumes. The speed with which this transition happened has surprised many dealers. The fall in production of new cars and the decline in the level of trade-ins have also exacerbated issues surrounding stock availability and has resulted in dealers now having to source used vehicle inventory from non-traditional sources, i.e., on the open market. In addition, rising prices of new cars (as some manufacturers have had to maintain price harmonisation across Europe because of the fall in Sterling against the Euro) have pulled the prices for used cars up in their wake. In this environment of rising residual values, auction prices frequently exceed the predicted industry book price, posing an additional funding gap for dealers looking to acquire suitable stock and also introducing a working capital issue often ignored.

However, the recovery in residual values has resulted in a one-off profit on used car stocks for dealers (as they disposed of previously fully written-down cars in early 2009), and has been a significant contributor to the stabilization of dealer performance in the first half of 2009.

With all these constantly changing factors, it is likely that used car trading will continue to be difficult, with reduced volumes and tight margins for the rest of the year. However, residual values should continue to hold up as the impact of the scrappage scheme (through the availability of cheaper new cars) is likely to be cushioned by the lack of availability of good used car stocks.

Ernst & Young point of view Used car sales performance is less likely to be susceptible to the downturn particularly as the recovery in residual values should provide a short-term boost. The main challenge facing dealers is their ability to purchase quality stock at reasonable prices in an environment where supply shortages are evident.

 
Aftersales

In the second half of 2008, many dealers reported an accelerated decline in servicing hours: customers seeking to rein in spending were delaying non-essential work and were less likely to succumb to 'up-selling'. Nevertheless, we believe that the strength of new car sales until mid 2008 should sustain dealer servicing volumes in the near term, as those vehicles continue to trickle into dealers' servicing bays.

Our view is supported by conversations we had with a number of after sales managers and dealer group board members over the past year, which supported a link between servicing revenue performance and recent new car sales volumes. As a result, the decline in servicing performance will be felt differently by dealers of different marques, with dealers representing brands who have lost market share in recent years facing steeper declines in after sales revenues.

Franchised dealers' view of trend in servicing hours

 
However, the overall slump in new car sales experienced in the second half of 2008 - which continued into 2009 - will lead to weaker demand for servicing and parts from franchised dealers in the medium to long term, with negative consequences for dealer profitability.

This outlook contrasts with the trend in aftermarket spend around the 1991 recession where dealers were still benefiting from record new car sales in the years immediately prior. As a result, aftermarket spend growth did not hit its low point until 1994, and this lag effect carried franchised dealers through the worst years of vehicle sales.

Historical relationship between new car sales and car maintenance spend

 
Some dealers are attempting to address the declining number of younger cars by making a concerted effort to retain the servicing of older vehicles and follow the 'bulge' of car sales, albeit at the likely expense of margin. However, in combination with better build quality, longer service intervals and a trend towards smaller vehicles, the future outlook for servicing volumes - both in terms of servicing hours and frequency - will be downwards for several years to come.

Ernst & Young point of view Aftersales has been and will remain the largest part of franchised dealers' business in profit terms. Overall, we expect dealer servicing levels to be in long-term decline as improvements in build quality, reducing warranty work and lengthening servicing intervals factor through on top of a shift to a less favourable pare age profile. Despite this, the high volume of new car sales made in recent years has served to shield franchised dealers of certain marques from this erosion, and dealers have become increasingly sophisticated at 'locking-in' customers through servicing plans and use of IT.

 
Conclusion

The sector is currently experiencing the effects of the worst recession for 50 years, and a swift recovery is unlikely. Going forward, franchise dealers will have to learn to cope with a declining aftermarket and slow growth in new car volumes from a much lower level than in recent years, of which a greater proportion will be comprised of smaller vehicles sold at a lower Profit Per Unit (PPU).

In 2009, franchised dealers were shielded from the full effects of the downturn as servicing volumes remained resilient, sales of small new cars benefited from the government scrappage scheme, and the recovery in residual values provided one-off gains on used car stocks. However, there are still real uncertainties around vehicle manufacturer stability, the availability of finance and the aftermarket -both under pressure from consumers suffering in the downturn as well as a declining pare of newer cars - which are all likely to adversely impact dealer profitability over the coming year.

As a consequence, we expect the number of dealer failures and site closures to accelerate in 2010, as the full effects of the current drop in new car sales are felt. The franchise dealers best placed over the coming months will be those able to retain a significant proportion of customers' aftermarket spend and representing growth brands. This is particularly true for those offering a strong line-up of smaller vehicles, which are proving more attractive to private buyers in the present climate and will provide the aftersales volumes in the months to come.