The path to profitability: A call to action for all dealers

July 19, 2010

Recently, I received a note from a successful Velocity dealer stating in part that they’ve experienced difficulty with appraisals of late. Part of it being that they are stretching so far to make new car deals they’re often putting too much into a trade. His desk managers are really finding a larger disconnect between auction values and what other similar cars with respect to miles and trim are selling for on the internet.

Following is my, response which I believe is relevant and constitutes fair notice for the broader industry.

There is no question that the pain being experienced with respect to appraising vehicles for acquisition and the amount that’s necessary to be paid at auction isn’t justified when you consider the retail market.  I’ve been speaking incessantly over the past year about the rapid increase in wholesale values without a corresponding retail price increase.  The effect is a highly compressed margin environment.  There are identifiable reasons for this compression; however that’s another discussion, and it will not likely change in the future.  In other words, this is the reality of the current and future retail automotive environment.

Although the industry is struggling to accept this margin compression, it’s clear that it is the reality of all efficient markets.  Specifically, this reality begins with the recognition that profit margins will be much smaller than they were in the previously inefficient market.   This new reality sets up two important questions.  First, will there be a race to the bottom where no one makes any money?  Second, if not, who are the winners and losers in such an environment?

With respect to the first question, the answer is no, there will not be a race to the bottom where no one makes any money, in fact some will make plenty.  The support for this position can be found by examining some of the most efficient markets in the world.  Such markets include mercantile and commodity exchanges, markets where everyone has access to relevant information with lightening speed.  In these markets there are certainly winners and losers, but to be sure, the profit margins are razor thin. 

So who are the winners in these most highly efficient razor thin margin markets?  They are the companies that possess two essential characteristics. The first characteristic is the company’s ability to perceive the price at which their products will sell at any given moment and their willingness to offer the products at that price point without delay.  The price at which the product will transact at the given moment is called “the equilibrium price”.  Sellers that either can’t see or are not willing to immediately move to the equilibrium price fail the first critical test of survivability in the efficient market. 

The second essential characteristic of efficient market winners is a highly cost efficient operation.  Since the profit margin at the equilibrium price is razor thin, less efficient operations can not survive for long at that pricing level.  If and when too many sellers meet the equilibrium price, the equilibrium price will drop and thereby systematically weed out those sellers with marginally less operational efficiency.    In such circumstances, only the most efficient operations have the ability to hang in there, endure the pain and temporarily survive at the almost non-existent and sometimes even negative prevailing margins.  Under such circumstances sellers of less efficiency will exit the market in favor of more profitable opportunities which could mean soy beans instead of corn, compacts rather than SUVs, or maybe storage facilities instead of dealerships.

The good news is that as the less efficient operations exit in favor of better opportunities, the equilibrium price will then begin to rise.   The profits of the most highly efficient operations will soar as a result of their extraordinary efficiency.  Once the profits for the most efficient operations climb to a high enough level, the other less efficient competitors will again return to this sector searching for a share of the profits.  At this point, the cycle repeats itself over and over.

The bottom line is that the reality of the ever more efficient retail automotive market is lower margins.  There will, however certainly be winners and losers. The winners will possess the two essential characteristics of being able to move immediately to the equilibrium price and hang in there until the less efficient are flushed out by the inefficiencies of their operations.  This new paradigm for the retail automotive industry poses challenges at multiple levels. 

First and foremost is the industry’s culture of pursuing fat margins in favor of moving directly to the equilibrium price.  This cultural resistance is presently allowing velocity dealers to significantly improve their market share.  Another significant challenge, however, is the restructuring of their businesses to create more efficient operations. Only some of this restructuring can be achieved through conventional cost cutting and expense control.  Fixed expenses such as land and facility costs are prime examples of those that can not be easily or quickly reduced.

Because the greatest cost efficiencies, and to be sure the hardest ones to achieve, lie in the dealership’s organizational structure and processes, it is now time to take inventory of all the necessary tasks and to eliminate all non-essential ones. This effort requires hard choices to be made between the nice-to-have and the must-have.  Manufacturer and consumer expectations make these choices extremely difficult but no less necessary. It is simply not possible for a business of extraordinarily low margins to be all things to all people. Moreover, the remaining tasks must be reengineered to achieve effectiveness with lower cost. This too will require tough choices involving employees and relationships with outside entities.  

The present moment in the industry is one between from where we came and where we are headed.  Although there is a growing trend of dealers characterized by the velocity movement that are learning and executing the principles of velocity management, there are many others that have simply adopted the practice of equilibrium pricing.  The consequence for such dealers that are willing to price at or near equilibrium without attaining greater operational efficiency has not yet been realized.  Without question, over time this group of dealers will experience results that will cause them to retreat from the market by either reverting to non-equilibrium pricing or pursuing other more attractive investment opportunities.  In the meantime, the entire industry is experiencing the pressure of a market place in transition.  Long term survival and profitability will depend on dedication to and a clear understanding of market efficiency and velocity management principles.