Sunday, 30 April 2017

Some further thoughts on automakers and auto credit - the UK market

As a footnote to my analysis of the US automakers and the credit cycle it is worth mentioning the way that credit in car sales is actually magnifying a trend which is likely to accentuate a cyclical downturn in demand from a drop in lending. 

In the UK back forty years ago most people bought cars with cash - or had company cars back when taxes were higher and perks were less punitive. Either way car sales relied on hard earned cash and people kept and cherished those cars often for many many years with good cars passing down through the family.

Today instead we have PCP - this is not the illicit hallucinogen although it may have similar effects on the auto market in particular used car values. Personal Contract Purchase deals allow people to finance a new car with a modest deposit and series of monthly payments typically over say a 3 year period. 

Now at the end of the PCP period you can either purchase the car outright for a given figure, walk away and not have a car or take the dealers favourite sales option; take the difference between the guaranteed value and their determined market value (assuming it is positive due to good residuals) and carry this over as 'equity' in another car purchase under PCP reducing your next deposit.

To my mind there are two significant issues with this (i) Usually PCP deals have limited mileages say 8,000-10,000 miles per year in order to guarantee the minimum value. So essentially you the consumer pays off the depreciation on a new car (which is eye watering and usually around 50% of the value) while it sits on your drive and you can't take it on holiday because you fear breaking your mileage clause. What a great deal, for the dealer. They get a nice, low mileage used car to sell 'preowned' and 'approved' to the next consumer off the lot (since 4 in 5 PCP people do not purchase the car at the end). And you just had the privilege of paying off the massive initial depreciation on a new car.

I think PCP is a bad deal for the consumer as you are usually still paying finance costs on a car but once the term completes you do not even own it. There is a sort of 'faustian bargain' here where consumers get their shiny new car and the manufacturer boosts its sales volumes. I am always suspicious of such 'innovations' in finance. But there is one way that the PCP is bad for manufacturers (other than giving them enough rope to hang themselves) and that is these are non recourse loans - more on that in a moment.

SMMT UK Car registrations graphic

So why would anyone take this PCP deal? I suspect the origins lie in the last crisis (as they so often do). Try and find a used car from the 2008 - 2011 period. They are rare because consumer spending collapsed, not just that rental fleet managers also cut back on purchases. This meant used car prices firmed up a lot in the period following the crash against what had been the underlying trend. Which meant your 'equity' went further when making that next purchase reinforcing the cycle.

This leads to my second issue (ii) - with the huge rise in car sales driven principally by PCP deals used car prices must soften as the cars sold in the 2012-2017 period are recycled onto the market in far greater volumes. This already seems to be happening and hence the poor performance of car rental shares in Hertz and Avis as residual values soften. 

Now what happens when residuals soften and consumers are feeling the pinch on incomes as we are seeing in the UK with terrible real wage growth since the crisis? Well they now find they have no equity when their PCP deal ends - not only that they won't have the cash savings to buy the car outright at the end of the term either. Sales collapse. 

They hand back the keys and try and find something to drive either downsizing to a cheaper model with smaller deposit or buying a 'clunker' for the medium term and there are lots of those from bumper sales in the 2012-2017 period. Either way; sales collapse.

The secondary effect for manufacturers is that this hit to volumes then also happens at the same time as the automakers financing arms are taking the hit on cars which have a residual value below the guaranteed future value given to the consumer. Therefore unlike a UK mortgage these financing deals have no recourse except in the case of damage and mileage.

Therefore all car makers selling in the UK have a vested interest in high residual values of used cars even as they fall over each other every year trying to sell as many cars as they can into the market.

Now consider what happens if sales demand declines due to a lack of consumer appetite and finance:

Automakers have huge factories and tonnes of capital tied up in them. They have to keep making cars and ultimately they have limited pricing power (unless we are talking Ferrari). So I suspect they will have to slash prices further and offer all kinds of deposit free, interest free financing to keep selling cars. The juicy profits of the credit divisions will have to take a hit. 

Google Finance: European automakers since the crisis

Essentially my theory is the UK at least (and likely the developed world) is awash with cars. 

Now all those cars still exist in the world, albeit with higher levels of built in obsolescence than the great cars of the 90s. I am talking about UK specific issues but auto finance is something which effects most international markets. So my medium term forecast for automakers is cyclically negative. I foresee falling sales, falling residual values and losses on finance.

Disclaimer: I have no interest at present in any of the stocks mentioned in this article. This article contains opinions not investment advice. If in doubt read my disclaimer.

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