Two Choices to Deal with Dramatic Increases in Wholesale Vehicle Costs

I just got off the telephone with a dealer who was complaining he hadn’t been able to buy a single unit at the auction today. He claimed every car he wanted went for over $3,500, and with a cash-in-deal policy of $2,500, an average reconditioning expense of about $700 and an average customer down payment of just under $800, he just couldn’t make $3,500-cost vehicles fit his business model. Although the numbers may have been a little different in each case, he is certainly not the first dealer I have had that discussion with.

July’s Manheim Used Vehicle Value Index was 125.9, which represented a 5.9 percent increase from its year-ago level. In January 2009, the index stood at 101.7, just a little higher than the benchmark value of 100 created when the index started in January of 2005. It has steadily risen over the last two-and-a-half years, reaching a record high of 127.8 in May of this year. What that basically means is that a car that sold for $4,000 in January of 2009 would cost $5,000 today. This 24-percent increase over the last two-and-a-half years has proven costly, and sometimes even deadly, to dealers engaged in dealer controlled financing.

Let’s take a look at what cash-in-deal is. Every time a dealership finances a vehicle, a certain amount of the money the dealership has invested in that vehicle is not recovered even after the customer’s down payment. This amount is the cash-in-deal (CID). It is the original cost of a vehicle plus all expenses minus the total cash down and the net trade allowance. In order to ensure the dealership properly manages the cash it has available and make certain the dealership maintains proper capitalization, the dealer must establish a dollar amount of the maximum CID allowed, which then also establishes down payment requirements and inventory replacement cost. The CID policy is designed to control the utilization of cash on a per-vehicle basis.
  
Your business model determines your inventory. The amount of money you want to risk every month divided by the number of units you project selling equals your average CID. The average CID plus the average down payment you expect to collect from customers equals the average total inventory cost you must maintain. The average inventory cost minus the anticipated reconditioning expenses equals the price of inventory you should be buying

For example, let’s say you have a pool of $480,000 to loan:
$480,000 / 12 months = $40,000 per month
$40,000 / 20 sales per month = $2,000 per sale CID
$2,000 CID + $700 Avg. Down Payment = $2,700 Inventory Cost
$2,700 Inventory Cost - $500 Avg. Recon = $2,200 Avg. Purchase Price

A $1,000 increase in CID in your business model may require as much as an additional $250,000 to $300,000 in capital in just one year for a small dealer.

Given the dramatic increases in wholesale vehicle costs over the past two-and-a-half years, dealer-controlled-financing dealers have faced two choices:

1. Increase their CID policy. Established dealers with a sufficient number of accounts to generate the necessary increased funds through incoming car payments have faced less of a struggle, but their cash flow has still been affected dramatically with more of the available capital tied up in inventory. Smaller dealers who choose this option have generally needed to find additional sources of capital through private investors, loans, floor planning of inventory or selling accounts. None of these options are particularly desirable, but they have become a business necessity for many.

2. Maintain their current CID policy, which results in offering their customer older, higher-mileage vehicles. In a Manheim study, vehicles purchased in a six-week period from April 1 to May 15 of 2009 for $4,000 to $5,000 averaged 85,272 miles. Vehicles purchased in the same price range during the same period in 2011 averaged 111,896 miles—a 31-percent increase. This alternative is no more desirable than the first, but it is the reality for most dealers with no ready source of the available capital needed for option one.

Increased CID means a higher selling price, and since the average down payment collected from customers has remained fairly steady for a number of years, the only two ways available to adjust retail installment contract terms to account for the higher selling price is through either higher payments or longer terms. Since average personal incomes have also not risen in a number of years, and in some cases have decreased, higher payments are a road that must be travelled carefully. It makes the verification process in underwriting I discussed last month even more critical. The fear with extending the length of contracts is that longer terms can produce two different problems that can have detrimental effects on a dealership:

1. The typical dealer-controlled-financing customer changes jobs and residences more frequently than does the general populace. A longer term increases the risk that your customer may experience a change or an event in their life that will negatively affect their ability to pay.

2. Longer terms also increase the risk that the vehicle itself will have mechanical issues beyond the customer’s ability to repair. Terms that run longer than the expected life of the vehicle can have a devastating effect on collections and charge-offs.

New car sales, the engine that drives wholesale used car values, have averaged about 11.7 million vehicles over the past three years. According to JD Powers, that level is expected to rise to 12.6 million vehicles in 2011 and 14.1 million in 2012, but Edmunds.com predicts new car sales will not return to the pre-recession levels of the 16.1 million vehicles sold in 2007 before 2016. That means while we may see some easing of used car wholesale prices over the next few years, this era of high used car prices is liable to be with us for several more years.

Waiting for used car wholesale prices to go down will not make this issue go away. Whichever method you choose to use – raising your CID policy or keeping your policy as it is and offering older, higher-mileage vehicles than you previously did – you must make the necessary adjustments to survive the new reality of higher wholesale prices.