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Lending to Automobile Dealerships
Credit Risk Management Issues
by Erik Day
In the November 1998 issue of The Journal of Lending & Credit Risk
Management, the author provided a picture of auto dealerships today and
then discussed "lending to" issues. This month's article zeroes in on spe-
cific challenges facing auto dealers and the credit risk management
issues they represent for lenders. The author then lists questions lenders
must be able to answer to help ensure successful loans to large and small
ore than 50 million new and used vehicles World economy. The Asian crisis is projected to
are sold each year in the U.S. In light of bring growth in the gross domestic product (GDP)
global issues and the financial exposure faced down to 2.5%, compared with 3.2% in 1997. A slower
Mby the U.S. banking industry, what are the potential growth rate, however, is more likely to persuade the
risks to the U.S. economy, and more specifically, auto- Fed to forgo raising interest rates, and that, in turn, will
mobile retailers and those institutions that provide help the long-term growth of the automobile industry.
financing? This is a difficult question to answer due to
the dynamics of the U.S. economy and its global inte- Home sales correlation. Buying a vehicle is still
gration and rapid technological gains. Evolution of considered a big decision and, for many consumers,
business has forced many forecasting models to be remains second only to purchasing a house. As such,
reevaluated in terms of how tried and true economic these two industries closely mirrored each other until
indicators will or will not impact the economy. recently. Data available from the National Automobile
It's Not Black and White Dealer's Association's (N.A.D.A.) Industry Analysis &
? 1998 by RMA. Day is dealer credit manager for World Omni Financial Corp. (WOFC), Deerfield Beach, Florida;
before that, Day served as an account manager for Ford Motor Credit Company, Coral Springs, Florida. WOFC is a
subsidiary of JM Family Enterprises, Inc., with more than $5 billion in annual revenues. Established in 1981 as the
captive finance source for southeastern Toyota franchise dealers, WOFC currently manages more than $1 billion in
commercial loans as a dedicated national auto finance company.
82 The Journal of Lending & Credit Risk Management December 1998
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 EXPANDED TO 7.2%. FURTHER America; in the next two years, it
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- THE END OF 1998. which is a growing segment as evi-
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
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- DE A L E R S H I P S NOW ARE better equipped to understand these
alone or small franchise dealer- issues. However, the banking
ships are facing enormous pres- F A C E D WITH E C O N O M I C industry still represents a signifi-
sures from larger mega-dealers able DA 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 COMPETITIVE M A R K E T. must be able to comprehend this
the market, it may just be a matter TH I S I S E V I D E N C E D BY THE 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

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