Used Car Prices Aren't Sensible

I don't normally link to other blogs, but here is a neat little post on a behavioral economics study of discontinuity in used car prices. There's no particular reason a car with 49,900 miles should be much different from one with 50,100 miles. But that's not what we actually observe. Pricenomics calls attention to a paper by Devin Pope, Meghan Busse, Nicola Lacetera, Jorge Silva-Risso, and Justin Sydnor (2013). "Estimating the Effect of Salience in Wholesale and Retail Car Markets." American Economic Review Papers and Proceedings (103(3): 570-74. As Pricenomies summarizes it in "How We Misprice Used Cars":

The researchers attribute the mispricing to “left-digit bias”. Buyers try to simplify the information available to them by only focusing on what they deem most relevant. And this bias represents $2.4 billion worth of mispricing.

Actually, the paper itself is quite readable. As the co-authors phrase it:

Modern economic life requires individuals to evaluate many pieces of decision-relevant information every day. A growing body of evidence shows that not all information is equally salient to consumers.¹ This is the case even for large-scale purchases made in well-functioning markets such as the market for automobiles...

The short paper above draws on the following, which presents the empirical details of their statistical tests for "irrational" pricing: Nicola Lacetera, Devin G. Pope, and Justin R. Sydnor (2012). "Heuristic Thinking and Limited Attention in the Car Market." American Economic Review 102(5): 2206–2236. That longer article is very much aimed at specialists. Thus prose such as the following:

Motivated by the literature on regression discontinuity designs (see Lee and Lemieux 2010 for an overview), we employ the following regression specification:

mike smitka

The Global Industry: Honda, the US and the Taper

http://www.tapirs.org/

Go to the URL to contribute to
preserving tapirs in the wild!

...bond markets reacted to the taper with a yawn...

The "taper" in practice started with a whimper not a bang. Instead of purchasing a $1.02 trillion SAAR the Fed reduced its purchases to $0.90 trillion – that is, $900 billion. Yes, the announcement suggested additional reductions at each FOMC meetings in 2014, but cutting purchases by $10 per month in several steps means the Fed is still poised to purchase another $500 billion in bonds, while promising to keep short-term interest rates at 0% until we get substantially lower unemployment or higher inflation, which in practice means well into 2015 if not beyond. In reaction, bond markets reacted to the taper with a yawn – rates at all ends of the maturity spectrum, from 1 month to 30 years, shifted 2-4 basis points at long maturities and actually fell out to 3 years. There's no sign that the markets whose entire focus is interest rates expect any effective change in monetary policy. (Indeed, I read it as saying that bond markets don't think taper or its lack matter – while stock prices are driven by the story of the hour and not by data.)

...the US is becoming an export base...

So what's with "global" and "Honda"? First, the dollar has appreciated relative to the yen – Japanese are looking at their domestic interest rates and judge that parking their money in dollars is the better choice. But if Abenomics works, their interest rates will rise. (And if it doesn't, the decline of Japan's domestic auto market will accelerate; see an older post here on the interaction of a falling and aging population on the demand for cars.) But even if the yen stays at its current level, Honda will find it increasingly hard to recruit workers in Japan, and will find little reason to bet on the yen's exchange rate for deciding where to make global models. In that context, it is important to note that Honda has adopted English as its global language, replacing Japanese. Quietly, Honda has also reached the point where it develops market-specific products (for "market-specific" read "North America") in Ohio.

But the dollar has depreciated relative to the Euro and the Chinese RMB, and has strengthened (or at least not weakened) against the Canadian dollar and Mexico peso. The yen exchange rate is an outlier. In that context (Takanobu) Ito, Honda's CEO, notes that the company is expecting its North American operations to export 30%, up from the current 6%-7%. BMW already exports 70% of the output at its Spartanburg SC plant; I expect others to gradually shift in the same direction. Toyota noted that it will export 7,500 Corollas to the Caribbean and Latin America from Mississippi in its initial year of production there, hardly an impressive number but meaning that these vehicles won't be exported from Japan. If you Google firm by firm you'll find similar stories for Ford, Nissan and others. So the word on the street matches US International Trade Administration's analysis of Trends in Motor Vehicle Exports.

Given the lead times in building capacity and making sourcing decisions, such plans could slow if the yen remains sufficiently weak. At the same time, VW's construction of North American capacity means fewer imports from the EU. And in my visits to suppliers – I will visit 5 firms for the 2014 PACE supplier innovation award – I am hearing of plans to add engineers in Southeast Michigan and Northern Ohio.

Now to be honest this has yet to show up in the automotive sector trade deficit. Yet what I would normally expect to see in the data is that a recovery in the US would lead to a sharp upturn in imports without a corresponding shift in exports. We don't see that, either. I don't expect the US to ever turn into the export powerhouse that Japan once was; global growth means that global vehicles will be made in multiple markets. Tariffs in the BRICs reinforce that tendency. We also need to remember that productivity is up, and that manufacturing employment in the US auto and auto parts sector will therefore increase by less than output. Despite these provisos, it's clear that the US is becoming an automotive export base, and continuing to be an engineering center. It's a nice note on which to end the year.

For background, compare US Treasury Yields and European Bond Rates. When the EU begins growing properly – which as with the US may require several years – then interest rates should rise relative to those in the US and make Euro assets more attractive relative to US dollar assets. I thus expect that over time the Euro will appreciate / the dollar depreciate. However, the timing is sufficiently uncertain that investing on this basis is not likely to pay. If it would, then big money would already be doing so and the Euro would already have appreciated ... whatever the weaknesses of the efficient market hypothesis, there is plenty of evidence that such predictable movements get arbitraged away, leaving markets sufficiently unpredictable as to not offer consistently prfitable strategies.

US$-Mexican Peso	US$-Chinese Yuan
US$-Japanese Yen	US$-EU Euro
Auto Sector Imports & Exports, 1965-date	Auto Sector Imports, Exports and Sectoral Trade Balance, 1980-date

The Best Car Ever

Guest post by Blake Grady, edited by the prof with comments from Econ 244 participants. Original was from May 17, 2013.
This is one I had in draft form but apparently forgot to publish last spring – my apologies to Blake and commenters

Tesla Model S

Consumer Reports recently gave the Tesla Model S a score of 99 out of 100, and other media outlets immediately began proclaiming that the car could be the best vehicle ever made. A small number of journalists responded by arguing that the entire idea of a "best car" simply doesn't make any sense.

...the entire [ratings] concept ... makes no sense

Does this vehicle look comparable to the Tesla Model S?

I agree with them, but I drew an even more extreme conclusion from reading about the car and the consumer reports rating system: the entire concept doesn't make any sense. People buy cars for remarkably different reasons: perhaps a Range Rover to drive around Manhattan in isolated comfort, or the same Range Rover to tow horses to a show. In this case, even with the same vehicle, it would receive two different ratings: one of the New Yorker and one for the horse owner.

This issue becomes worse when trying to compare different vehicles. Comparing an F-350 pickup to a Tesla Model S on the same rating system is almost impossible. The question then becomes why do journalists use this system? My guess is that reviewers have found that people find the ratings systems more interesting when they can compare all of the models together, even if they make less sense that way.

The prof pointed out that such rankings have two audiences. One is the car guys (and gals) who like to argue about features and driveability and styling. Ratings are great to spur discussions over beer (or, perhaps for a Tesla, wine). The other are car purchasers, who are likely to look at sites that compare cars within the same segment. For them, these grand competitions and “best of the best” ranking games are not meaningful, as you point out. However, cars are an aspirational purchase, and “halo” cars and the general image of a brand matter. If nothing else, you want all your cars to have decent to good ratings…

Tyler Kaelin agrees as one of those car guys. Although I read car reviews all the time, my parents (people who have actually bought cars before!) could care less. Their concerns are general reputation in terms of quality and reliability, price, and the test drive. Where does that leave the purpose of these reviews, I begin to wonder? Maybe they are part of that “general reputation.”

Griffin Cook notes that a unified rating system makes sense given a very specific [strong!] requirement: that it is based on the “drivability” of the car and ignores function. In this sense, the slower, less fuel efficient F-350 is a lesser car then the Model S. While a pickup truck is obviously meant to serve a different function, the point of a view of a driver behind the wheel matters. However, Consumer Reports is not that narrowly focused, and their subjective reviews do not provide consistent information for potential buyers who consider their opinion to be authoritative.

Daniel Tomm seconded Blake: the rating system does not make sense if comparing an SUV to a sedan. It would be fine if they had different classes for each type of vehicle (i.e. SUV, light truck, heavy truck, sports car, sedan). Each vehicle serves its purpose — though I do not know what category concept cars such as the ME.WE would fall in. Personal preference makes a difference and like Tyler and the professor said, the car purchaser has the ultimate say. I know when I was first looking at cars, trucks were out of the question because my father thought they were impractical and I would never be lugging around logs or construction equipment. In terms of reviews I never truly looked at “best of the best” but if I saw a car I liked and a friend drove it I would ask their general opinion in order to get real feedback from someone who was not trying to sell me the car.

Auto Recovery, yes ... but as for the rest

by mike smitka

The US recovery continues at a snail's pace; the auto industry is doing better. The rise in the SAAR [seasonally adjusted annual rate of sales] puts us below the bubble-inflated peak of 2005-6, but given subsequent population growth is at a more sustainable level. Other auto-related indicators show marked improvement, but suggest we still have a ways to go. First, the share of the auto industry (retail and manufacturing) was at 2.3% of the labor force in the late 1990s; it then fell steadily to 2.0% before falling off a cliff in 2008. The nadir was 1.6%; today we're back to 1.8%. That is only about halfway, assuming that other structural changes in the US (the continued growth of healthcare) makes it possible to return to the days of yore.

...automotive employment's only about halfway back...

If we look at the details, we get a more nuanced story. The retail side (which includes auto parts and not just vehicles) peaked at about 1.9 million workers; it fell by 300,000 during the Great Recession, and is now 2/3rds of the way back to that level. Manufacturing took a harder hit, falling from 1.1 million at the start of 2006 to 1.0 million in 2007, before dropping by 400,000 in 2008-9 to just above 600,000 workers or less than half the level of the late 1990s. We're now back to almost 850,000, a sharper rise than in retail, but with further to go. Yes, suppliers are running at more than 100% capacity, and that must normalize. So employment will rise further, as overtime and other expedients are replaced by permanent hires. Still, it's not clear that the US is on track to get back to earlier levels, though over the next few years other changes may help (e.g., Honda's goal to export 30% of US-based production).

But overall the story from labor markets is of an anemic recovery. As the baby boomers retire, the growth of the working age population will slow. At present, however, we're only just keeping up with population growth, and the gap between "normal" employment (I tracked age-specific levels back to 1994) is large, roughly 9.1 million workers as of November 2013. Furthermore, more jobs are part-time while a sizeable share of the labor force that had been working employed full-time are still working short hours. If we adjust for that, we're shy 10.8 million full-time jobs. Let's not forget long-term unemployment either, the 27+ week component is improving but is only down to what had been previously been the historic peak.

Finally, this is not due to boomers entering retirement early. Indeed, participation of older workers has trended up throughout the Great Recession and subsequent recovery. In other words, they aren't retiring with past rapidity. That's part of the reason that prime-aged participation rates remain below historic levels. Again, I've traced these levels back much futher – they were essentially flat going into the Great Recession. Now we can see a small increase since the worst of the recession, but only by about 1 percentage point to 95% of the previous norm. And the rate for young workers (age 20-24) remains in the abyss.

      Click on the graphs to expand!

I've added the export graph (vehicles, engines, parts) from the St Louis Fed "FRED2" data service

Beanie Babies for Billionaires

As Mainstreet.com phrases it, "kids love collecting." Think Beanie Babies and Cabbage Patch Dolls. Adults, of course are the ones actually doing the buying of would-be collectible toys. Left to themselves, we – guys, anyway – lean towards baseball cards, comic books and hand tools. Among the monied class the list includes wine, cars and mechanical watches. For them BitCoins are the latest fad. There's a bit of mystique, because the technology behind them is complex, so it appeals to technophiles. There's good marketing, with claims that Bitcoins will be secure, anonymous, and free of any government hand. Ideal for that arms shipment? And above all, there are limited numbers, a function of the mathematics of the system.

There's also a whole make-believe world to go along with them. Markets work perfectly. Ah, maybe not so perfectly - you've got a chance for monopoly! There's a romantic storyline, celebrity twins in the Vinkelvoss brothers and Austrian intrigue over monetary systems in a story that's sufficiently convoluted to permit wild flights of fancy.

...BitCoins are virtually harmless...

Then there are the marketing links that give a modicum of respectability, and give hypsters a way to cash in, or cash out. So far though, there's no offering on Nickelodeon. Fads come and go, in ways unpredictable. Cabbage Patch dolls have never gone away; you can still buy Beanie Babies on eBay.

Could BitCoins ever be something more that a toy? I think not. To serve as money, they have to be widely acceptable. With a maximum geologic reserves of only 21 million, diminishing returns have already set in to mining - Bloomberg reported in April that "miners" used $174,000 of electricity a day, enough to power 31,000 homes; that amount is now surely greater. But we in the US live in a society of 315 million people, and in a world of some 7 billion. Even finely subdivided, there will never be enough BitCoins to support the daily transactions of even a middling city. Furthermore, we live in a dynamic world, one that on average is growing. BitCoins by design can't grow with it. Or shrink, if an economy moves into recession. Their value, in terms of goods and services, could never be stable.

Stable they are not. When BitCoin prices are going up percentage points a day, who would want to spend them? When they fall at a similar clip, who would want to keep them? As a virtual entity there's no firm foundation to their value, and there's no central bank (or, for diamonds, no de Beers) to try to set a stable price. This isn't just hypothetical: so far today [December 7, see here] prices have ranged from a low of $780 to a high of $860 and as I write this have fallen to $820. That's an upswing of +10% followed by a drop of 5%, all within a few hours. Over the past month the range is from under $400 to a high of $1200. How can you use this as your daily currency when you have no idea whether you need 1 BitCent or 3 BitCents to do your shopping? Even arms dealers will shy away from them!

Nor would transactions remain cheap. Bitcoins are subject to theft by computer hackers and can be lost if a hard drive crashes. Setting up systems to use them requires being a nerd. For them to be widely used, they'd have to be built into the software used by the local grocery store, tied into payment by cards that could be swiped and automatically cleared against bank accounts to settle bills from suppliers and make payroll. All of this is tied to the ability to borrow and lend. Credit cards aren't cash, they provide loans backed by banks who in turn provide assured payment to stores while bearing an assortment of risks. The idea that a virtual currency could somehow eliminate the costs associated with a financial system is ludicrous. It is based upon a utopia in which "hard coin" is all that exists, where consumers carry around in their pockets all the cash they might need for the week, and where they need neither borrowers nor lenders be. Outside such a utopia, bitcoin transactions will carry fees. (For wonks, they already do: look at the bid/offer spreads on BitCoin exchanges!)

As for me, I've accumulated a modest number of Chinese scrolls and Japanese woodblock prints, of minimal resale value. I've a few potentially collectible books, such as an account by a German visitor to Japan, published in 1888, replete with hand-tinted engravings, and a signed first edition of Tom Wolf's first book, The Kandy-Kolored Tangerine-Flake Streamline Baby, my copy for reading when I assign his seminal story in Economics 244, my Spring auto industry seminar. My copy shows use, and on a rotating basis my scrolls and prints hang on the walls of our house.

Reading isn't an expensive hobby, but taken across the globe, people spend a goodly chunk of money on it, and by and large benefit from it. Children got playtime with their Beanie Babies, at least as long as their moms didn't lock them up to keep them in pristine condition. I'm not sure what sort of psychic pleasures billionaires get. In any case, let them play with BitCoins; they are virtually harmless.

mike smitka

China: The Domestic and the Global Industry

In October 2013 sales in China reached 1.92 million units – see the China Auto Industry Association statistics page for details. That's just shy of a 24 million unit rate, and is surely the largest number of vehicles ever sold in a single market in a month. For GM, sales were 282,000 units – 25% more than US sales that month. Everyone is in the market, or preparing to enter there. The Korean neighbors (Kia and Hyundai, but also Daewoo as part of GM), Japan (or at least the Japan Three of Toyota, Honda and Nissan, and Mazda and Suzuki), Germany (BMW, Mercedes, VW), the Detroit Three and now the French, both PSA and Renault. A host of local firms continue, though most as paper entities. Still, Great Wall, Chery, Geely, BYD, Changan and others.

This raises a host of questions. I focus on two: geography and profitability. I frame my brief analysis using the perspective of the OEMs. Since more and more value added lies with suppliers, that may lead to inappropriate conclusions, but for now I will accept the status quo terms of debate.

...the geography of China's automotive industry makes no economic sense...

First, despite very large production volumes, a side effect of government policy has been to disperse production widely. Even though the Third Front policies of the 1960s are widely understood to have been a failure, the political economy of joint venture approvals has led to factories in locations that make little sense. Today, with the market supply-constrained, that matters little. As competition heats up, however, the costs that accompany scattered locations will become more and more burdensome.

Second, there's profitability. On a global basis, the dark secret is the industry depends on the US market for a disproportionate share of profits. Japan's domestic market is in long-term secular decline, and will remain fundamentally unprofitable despite the dominant position of Toyota. (Suppliers seem to be able to collude with impunity – or so they thought – but Toyota hasn't been successful in being a price leader.) Europe is little better, offset only because of a richer product mix. How profitable is China? To my mind that is the single more important strategic variable the industry faces.

Back to geography. Under Mao local governments were expected to fend for themselves, first and foremost in terms of food but extending to a wide variety of industrial products. Fearing a Soviet attack, Mao deliberately dispersed heavy industry into remote locations. So at the onset of post-Mao reforms, every province and most large cities turned out trucks and passenger cars, even if only a handful a year. In total there were perhaps 120 producers. But political power was likewise dispersed; up-and-coming party officials were rotated through a variety of posts, but anyone slated for top leadership served a stint as a provincial governor or mayor of a prefectural-level city such as Shanghai. To be promoted to the senior leadership in Beijing required presiding over economic growth. So when the government looked to joint ventures to improve motor vehicle production, the result inevitably was one factory here, another there. Local protectionism – in Shanghai you found old generation VW Santanas, in Beijing you found jeeps – reinforced this desire to have your own plant.

China has no equivalent to the 600-mile-long I-75 "automotive alley" in the US, with an agglomeration of suppliers, assemblers and associated engineering centers feeding off of each other in a positive manner. Beijing is 1,300 miles from Guangzhou [Canton] in the south, and several automotive operations are another 400 miles to the northeast of Beijing. Similarly, at the western end of the zone is Kansas City, 700 miles from Detroit and 650 miles from Columbus, OH; Chengdu in the Sichuan basis is 1,200 miles to the west of Shanghai, across rough terrain, and Urumqi is 2,400 miles away.

Perhaps Wuhan will become a nexus – a recent Automotive News China story – but there is none at present at the assembler end. Perhaps suppliers are more concentrated, I know of several engineering centers in Shanghai, proximate to those of VW and GM, the two largest car companies in China. But what this means is that as competition heats up, and the segmentation of the country into regional markets eases, there will be numbers of plants whose location will saddle them with high logistics costs coming and going. As long as the government mandates joint ventures, politics will trump sensible plant siting. The geography of China's industry makes no sense, and will cost firms money.

...GM's & VW's Chinese ventures appear to be quite profitable....

Then there's profitability. Perhaps some suppliers break China out as a separate geographic region, but I've yet to find any. (My understanding is that parts suppliers are not under the stricture of forming joint ventures, though likely many of them have because local partners add value.) Assemblers however are limited to joint ventures, and at the two market leaders (GM and VW) their profits are accounted on an equity basis, rather than as part of normal operating profits. Both however provide that number. It's likely to be an underestimate. The biggest potential divergence would be if these ventures paid dividends; that would reduce retained earnings and the rise in book value. That is, equity income falls, though it would be offset by dividend income. However, neither media reports nor financial statements provide any hint of such payments. Indeed, it's clear that at present all funds are being reinvested. Instead, the (post-tax) equity income is an overstatement because both venture partners have an incentive to use transfer pricing to the hilt, as they get 100% of any excess, but only half if they let the venture book a lower price and higher profits. On the Chinese side that includes the provision of real estate; for VW and GM it would include licensing fees for intellectual property. Both firms have relatively new facilities, and continue to invest at a prodigious pace; they likely have high offsets for depreciation. And of course GM and VW can only report half of total profits.

To the numbers: in the first 9 months of 2013 GM International Operations, under which China falls, realized equity income of $1.4 billion; total consolidated GM profits were $4.3 billion, so the Chinese joint ventures accounted for 32% of the total (and 32% of unit sales). Another way to view the China side is to compare profits in North America with profits in China. GMNA is 6% larger unit sales, and GM China lacks the gold mine of full-sized pickups. But given GM's 50% share, GM's joint ventures in China earned $2.8 billion while North America pulled in $2.2 billion. China makes money.

VW's numbers paint a similar picture. The increased equity valuation of VW's China operations came to €3.5 billion in the first 3 quarters of 2013; total profits were €8.8 billion. China thus accounted for 40% of the total, on 32% of global volume. Of course at present Europe weighs down VW's profits. Nevertheless given its 50% stake, its joint venture partners in China earned €7.0 billion. Its operations are older than those of GM, so it will have lower depreciation charges; its Santana plant in Shanghai, which contained used equipment, is likely fully amortized. Its Audi brand is also the dominant luxury vehicle in China. Still, at roughly US$9 billion it substantially out-earned GM. The bottom line again is that China makes money.

So perhaps we will move towards a bipolar world, in which North America and China come to dominate global automotive profits. As the industry is currently structured, though, China's geography will remain an impediment.

Thanks to David Wiest for discussing equity accounting with me.

Energy Futures

The challenge of "green" is aggregating small amounts of energy – ultimately days of sunlight per surface^[1] – into amounts useable in quantity and continuity. Plants convert some of that energy continuously in daylight hours, but aggregating is the challenge. Currently we rely almost entirely upon a fossil fuel process that takes eons and is not sustainable – even if the amounts of recoverable fuels remains large, the environmental side effects are rising, not falling. Global economic growth has almost immeasurable benefits – hundreds of millions of Chinese no longer face hunger daily. Only recently has the government sufficiently overcome the fear of famine to eliminate the mandate that farmers grow grain. In China point- and regional-source pollution is now sufficiently bad to generate local political action, as it was first in California and then in the US as a whole in the 1960s. But no local government, and most national governments, are uninterested in denying access to electricity (air conditioning, refrigeration, lighting) or mobility (cars). Desirable or not, I don't think it's realistic to expect that governments will do much to repress energy demand. Supply-side developments are thus crucial. That means improving the feasibility of solar, wind, hydro and biomass.

One challenge is operational size. To what extent are economies of scale so intrinsic in the physics (and their engineering implementation) that only large facilities are feasible? Let me speculate on alternatives for wind power to frame this question.

Currently the trend is towards very large turbines. Winds blow stronger above ground; if you're building a tall tower, you then want to generate a lot of power per tower to cover costs. That may work, with better engineering of blades and generators and mechanical connections. Scale on the manufacturing side can help, as standardized designs lead to economies in production, from poles to turbine blades.

What would a small system look like, something found in every backyard? First, the turbines would have to be short and spin on a vertical rather than a horizontal axis; they couldn't look like windmills, but rather spinning windpoles that would face different wind sheer and so might be cheaper structurally – the pole would be the turbine access, with lower stresses cheap bearings or even bushings would do. Now close to the ground they'd "enjoy" far less wind, so would have to be really cheap. Windpoles might be relative to windmills on a watt-hour basis.

Then there's the aggregation issue. Such windpoles probably couldn't each turn a generator, that would be too high in cost per unit of energy. They might however be able to turn a small scroll compressor that would feed through standard lines to a centrally located turbine. Scroll compressors are pretty well understood, there are lots of refrigerators and air conditioners out there. Storing compressed air is also a mature technology, providing a means to enhance continuity. Small air tools – small turbines – have also been around a long time. So the pieces could be assembled quite readily.

I'm not enough of an engineer to cost any of this out. There may be simply too little wind energy at ground level. But versions of this – systems whose cheapness and small size make up for conversion efficiency – seem worth exploring. Perhaps they already have been, and have been found wanting. But in some parts of the world small rooftop solar water panels are pervasive – highly inefficient in the amount of energy they convert but so cheap as to make sense.

...[we'll see] a multiplicity of energy systems … [as in] vehicle drivetrains

In any case, any attempt to move away from fossil fuels is likely to lead to a multiplicity of energy systems – just as we are currently seeing a growing variety of vehicle drivetrains, depending on local fuel options and driving patterns.

mike smitka

Note 1. Nuclear – including geothermal – and tidal sources are exceptions. While in principle fusion is possible only uranium-based fission is commercially available, but that suffers from both political and economic pressures that make it a small slice of currently harnessed energy. Geothermal and tidal energy are at present unimportant.

What’s With the Higher New Vehicle MSRPs?

Ruggles – AFN – Dec 2013

The price of new vehicles has been rising at a steady rate despite record auto manufacturer profits.  This has been accomplished by just raising the price, through added content to base vehicles, and reduced expenditure on incentives. What is driving this trend? I see no evidence of any real movement in manufacturing costs. Labor costs via the D3 UAW contract are locked in for the next few years. What’s the deal?

Many believe the industry is preparing for the inevitable interest rate rise which will most certainly begin as early as next spring. Providing we get through the next round of debt ceiling issues in Congress in one piece and the economy remains resilient, new Federal Reserve Chairman Janet Yellen and her Board of Governors will need to begin backing of the level of stimulus the Fed has poured into the economy. That means interest rates have to rise.

Our industry has been enjoying the longest span of low interest rates I’ve seen in over 40 years. Dealers are often in the position of being in a positive cash flow position on their floor plan account, receiving more from their OEM in floor plan subsidy than they pay out in interest to their floor plan lender. Many have been lulled into thinking this is the way it is supposed to be, and that it will continue. I don’t normally make predictions, but I can guarantee that this is NOT the case and it will NOT continue. Our industry needs to brace for more normal interest rates. I believe that is exactly what the OEMs are doing.

The higher MSRP prices mean OEMs are positioning themselves to be able to offer below market interest rate subventions in an attempt to maintain volume momentum in the face of the inevitable rate increases. While subventions will most certainly be offered through OEM captive finance arms, manufacturers might also need to offer enhanced incentives for those buyers the “captive” doesn’t want to finance, for either credit or advance reasons.

Regardless, the subventions will funnel more business to “captives” and away from independent banks and credit unions. We’ll also see continued growth in leasing through “captives” with significant money factor subventions. Independent lenders who lack OEM support need to prepare for the inevitable downturn in business.

Dealers need to prepare for a flattening out of vehicle sales traffic while consumers adjust to the new reality. Dealers also need to prepare for a rise in floor plan costs by watching their inventory levels more closely. This hasn’t been much of a problem given the recent balance between production and demand, but a flattening out of sales traffic could change that quickly.

The pre-owned side of the business will also be impacted. In particular, the Certified Pre-Owned business will see challenges. As real market interest rates increase, the payments on a Certified Pre-Owned vehicle will rise to where there won’t be enough difference between the subvented payment on a new vehicle and the non subvented payment on a CPO unit to warrant a consumer considering the CPO vehicle. OEMs who aren’t prepared to subvent on the CPO side of their business, and to offer residual based financing alternatives for consumers, could be in for a shock. As CPO sales slow and inventory backs up manufacturers could see a sudden decline in late model pre-owned values as dealers aren’t so eager to stock CPO inventory at the same level as they did in a market with the artificially low interest rates they have enjoyed for the last few years. Against this backdrop, there are hundreds of thousands of fresh lease returns scheduled to reenter the pre-owned market.

As ex Federal Reserve Chairman William McChesney Martin once famously said, “The job of the Federal Reserve is to take away the punch bowl just as the party gets going." This was in the context of raising interest rates just when the economy approaches peak activity after a recession. Given the long run of low interest rates and the dramatic increase in money supply through Federal Reserve Quantitative Easing, this axiom has never been more important.

The punchbowl is about to disappear and it’s time to prepare for it.

NADA White Paper on Incentives

I found the NADA White Paper on Used Vehicle Depreciation (pdf) interesting. Key sections are:

• Why we’ve seen so much volatility in depreciation in the past
• What to expect in terms of depreciation through 2014
  
• How external factors influence depreciation trends
  
• Which vehicle segments face a greater upturn in depreciation

Ruggles

“Buy a Car, Get a Check” and the recent NADA White Paper on Incentives

ruggles: the following is a collection of notes and has not a published column.

NADA recently published a long awaited white paper on incentives. While it is chock full of salient data and information, there are some things missing. I will try to fill in some blanks based on my own experience and perception. Before getting into the discussion, it is important to understand that the conclusion of the report, that incentives degrade residual values and therefore brand equity, is unassailable. My purpose is to add to the discussion.

I began my auto business career in 1970 in a Chrysler Plymouth dealership. Markup on full sized vehicles was 22.5% with a 2% holdback. At GM and Ford, I believe the holdback was 2.5%. There was an annual carry over allowance of 5% that Chrysler dealers counted on to move end-of-model-year inventory. At the low end, the markup was 14.5% on a Valiant or Duster.

No one was too worried about Toyota and Datsun in those days, but Volkswagen was certainly a factor. I have no idea what incentives and marketing strategies those auto makers used in those days.

My first recollection of “stair step” incentives was in the middle 1970s, perhaps as early as 1974. I recall a stair step incentive based on an assigned objective on Plymouth Valiant models. I recall a Guaranteed Value Program (GVP) on Chrysler Imperial leases that provided a $900 payment on leased Imperials to even out their resale value with a Cadillac Sedan de Ville. Those leases were privately capitalized lease company transactions. “Showroom Leasing” as we know it today hadn’t yet been invented.

To add additional perspective, a “long term” finance contract was 36 months in those days, with some 24 and 30 month terms occasionally used by borrowers. Borrowed down payments were fairly common, with a buyer trip to the “mouse house for a dip” being common in the vernacular of the day. An average interest rate was 6% ADD ON, which was about 12% APR. The Federal Truth in Lending Act had been passed in 1968 and even though the payment books of the day were based on an “Add On” interest calculation, the actual APR had to expressed on the bank contract along with the finance charge and the total of payments.

The first consumer rebate came about as a consequence of the recession triggered by the 1973 Middle East war and the OPEC oil embargo. Ex major league baseball player Joe Garagiola was everywhere with Chrysler/Plymouth advertising in 1975 with, “Buy a Car, Get a Check.” Chrysler led the auto industry in pulling the U.S. economy out of recession. There was considerable pent up demand and the new purchase activity quickly cleared dealer inventory, prompting them to order more. Soon the auto plants were humming again.

An ongoing problem in the economy was “stagflation” and the resulting MSRP price increases spawned the advent of 48 month term auto loans. In the run up to the 1979 Iran hostage crisis, and another spike in fuel prices, Chrysler was near death. They continued to build cars on speculation, as they had done for years, but the dramatic slowdown in sales stopped dealers from ordering inventory. That didn’t stop Chrysler from continuing to build. They stacked the unsold vehicles in every parking lot they could find. They booked the vehicles as assets, but they were running out of cash. It was common to see weeds growing up through the gap between the fenders and hood of these vehicles waiting for a dealer to order them. Thermostats rusted shut, resulting in engine damage when the vehicles heated up when they were loaded and unloaded for transport. These vehicles were largely odd ball color and equipment combinations as they were built with whatever parts Chrysler had available at the time. To move this inventory and produce sorely needed cash, Chrysler paid its dealers big money per vehicle up front, as well as offering a large consumer rebate. Chrysler drafted the dealers’ floor plan accounts immediately before shipping the vehicles, while paying the dealer for the purchase incentives and consumer rebates months later.

Of course, all of this crushed the company’s already weak resale values. I recall paying $4250 for a 1979 Dodge St. Regis in 1980. I bought the car for my parents. The vehicle had an original MSRP of about $10,400 and had 6,000 miles on it. As a percentage of original MSRP, these incentives must have set “all time” records. So did warranty claims. The best values were the low mile pre-owned vehicles that were everywhere.

While I don’t have “first hand” knowledge, I have reason to believe that similar measures were in place at the other domestic OEMs.

The industry saw another period of extreme production pushed via incentives when the domestic OEMs, in particular, short-cycled rental vehicles, producing large volumes of off-rental units at really cheap prices in the late 1990s. This situation created an opportunity for some of the most compelling pre-owned lease payments the world has ever seen. Lenders failed to account for the drop in residual value precipitated by the flood of rental returns to the market. So did the common residual guides. It wasn’t uncommon to see a lender guarantee the value of a vehicle 36 months out at a higher value than it could be purchased from auction a year old. The industry saw reverse amortization leases.

Astonishingly, the lenders, who took great pride in their “risk mitigation” departments, failed to pick up on this. The result was predictable. Many banks refrain from pre-owned leasing today because they think pre-owned leasing is risky. If they think they can guarantee the value of a vehicle 36 months from now at a higher value than it can be purchased for today, it might be a little risky. This same anomaly happened again in 2008 when fuel prices killed the current market on pre-owned "heavies."

...invoice hasn’t been “Invoice” for over 30 years

Against this historical backdrop lies my major point: Through all of this, banks still used “Invoice” as their “advance” or “amount financed” lending guideline. They still use it today. Invoice hasn’t been “Invoice” for over 30 years, as is well-observed in the NADA report.

Since the late 1970s, dealer transactional gross profit has moved from above invoice to below invoice. The average consumer pays less for a new vehicle than the dealer pays the factory when the OEM drafts on the dealer’s floor plan account. Gross profit has moved from “over invoice” to “trunk money.” The amount financed is MUCH higher as a percentage of dealer NET vehicle cost than it ever has been, while at the same time, loan terms have increased from 48 to 60 and now 72 months and higher. Now we see 84 and 96 month terms becoming common. Negative equity on a trade in is much more common than not, despite the recent strengthening of used vehicle values. That will be temporary, as it reflects a pre-owned inventory shortage resulting from slow new-car sales during the Great Recession amplified by Cash for Clunkers.

Bottom Line: Rebates go with extended term financing like peanut butter goes with jelly. Certainly, the approach imports have taken is preferable to that taken by OEMs who use customer cash. But as long as extended term is what is used to provide low monthly payments, consumer rebates and trunk money will remain with us, for better or worse.

But there’s more to this story! As mentioned in the NADA White Paper, there was a point where the OEMs began to reduce dealer markup over invoice. This has certainly contributed to dealership sales staff turnover as well as reduced new vehicle margin as a percent of sales. We used to make $1300 gross profit on a new vehicle when the MSRP was $10K - $12K. Reduced margin over invoice also helped fuel the move to gross profit as “trunk money” instead of gross profit over “Invoice.” Hell, some dealers START their deals from “Invoice” these days. Most consumers have been trained to feel they have the “right” to know the dealer’s invoice, and the industry has a plethora of vendors eager to give it to them. That genie isn’t going back in the bottle. But I find it interesting that so many dealers actually fund the same vendors who demonize them to the consumer one minute, while providing the dealer’s proprietary information the next.

The point is that our industry, on purpose or inadvertently, has made it a highly complex task to determine the actual net cost of a new vehicle. Dealership staff themselves have a difficult time figuring it out, as evidenced by the regular charge backs that occur as a result of factory incentive audits. The world seems to be clamoring for even more transparency while dealers know that if their own staff know their true net cost, they couldn't wait to give that away too. And there are always vendors to help that process along.

With the “stair step incentives,” Customer Satisfaction Index kickbacks, and purchase cash money on top of “First Time Buyer,” “Plumber,” "Realtor,” “Glass Company,” “Loyalty,” “Conquest,” “College Grad,” "Friends and Family" and “Military” incentives, who can figure it all out? To a consumer, it’s like drinking through a fire hose. A skeptic might think this is by design. I think it’s the only way our industry holds on to the embarrassingly low gross profits it maintains today.

While the NADA White Paper on incentives is salient, I’d like to add these points to mix for consideration.

Smitka adds that the transaction pricing variance – still there in the earlier days of larger differentials in bargaining skills – makes econometric studies of vehicle demand a challenge. Indeed, AutoFacts (now part of PwC?) began as an effort by a former GM economist William Pochiluk to build a database of prices that corrected as best as possible for invoice versus list and rebates by marketing region and date. Yet I've read papers published in top economics journals that use list price, though it's well-known that there are systematic and non-trivial price differences across the model year. Some is laziness in searching for better data, some may be the lack of budget to buy the cooperation of AutoFacts. Take statistical studies of auto demand with a large grain of salt!

The Best Selling Vehicles by State

David Ruggles

I found this chart from Dealer Communications quite interesting. Business Insider notes the following on the topic:

The auto industry has become so globalized, you can find the same Ford in Detroit and in Beijing. So it’s not surprising that Americans’ taste in passenger vehicles has become a bit homogenized.

To find how much difference there is in our car-buying habits, we asked Kelley Blue Book to pull the data from the start of the year to find the best-selling ride in each state.

Not surprisingly, Ford F-Series family of trucks dominated the list, coming in at number one in more than 30 states. But Americans elsewhere have different tastes: Florida and Maryland went for the Toyota Camry. Hawaii liked the Toyota Tacoma.

So regions persist – large pickup trucks are near-unique to the US and Thailand – amidst increasingly global tastes, as per an earlier post reflecting an interview with just-retired Ford Chief Creative Officer J Mays at World Cars World Trade.

Why Pay for Science?

Mike Smitka

In my Industrial Organization class we chatted about the logic of funding basic science in a world of which the US is an ever-smaller slice.^[1] The economic gains to basic research remain highly uncertain, and applications may not come for decades.^[2] Furthermore, science is mobile: conventions are international in nature, results – in economics, working papers indexed HERE – are disseminated rapidly. So aren't the incentives to free ride? At the level of a US state there's no obvious need to fund basic science, yet the focus of "flagship" universities is just that (and liberal arts colleges such as Washington & Lee face pressures from accreditation, reputation and faculty peer pressure to be mini-Harvards).

The public policy temptation is to free ride upon the R&D expenditures of others.

One retort is that while Science may be borderless, tacit knowledge remains important and "lab rats" and their equipment aren't mobile. The benefits come from commercialization, which benefits from ready access, hence we should find activities co-locating, with a research university the magnet. So there's a body of work on the geography of biotech firms and semiconductor firms, whether you get clusters of high-value-added enterprises with high growth potential centered around universities. I don't know the current state of the literature, but I strongly suspect that if you could undertake a cost-benefit analysis, the magnitude of the benefits of such spin-offs is a fraction of the cost of funding PhD programs.

Now in fact some states have been dropping their funding. In both Virginia and Michigan the public component of UVA (15%?) and UofM (5%?) is modest. In effect, they've become private schools building upon large investments in plant and equipment funded by state taxes but reliant on outside grants and alumni support for ongoing operations. What of a University of South Dakota or a University of Arkansas? Have they maintained funding? I don't know – it might be a good term paper topic when I teach the class in 2014!^[3]

In any case, research universities look to benefit financially from R&D technology licensing. The patent component of that can be tracked, but not all technology is covered by patents.^[4] Now I'm not sure that's a great argument when approaching the state legislature – doesn't that translate into a case for cutting support? But it certainly is part of the wider discussion of the benefits of funding R&D. So here the NYTimes science section reports that "Patenting ... Does Not Pay...". The underlying Valdivia Brookings study is part of a larger project on technology – see for example the Rothwell et al. Brookings paper on the regional nature of R&D. But what Valdivia focuses upon is the growth of Technology Transfer Offices. His 1999 base consists of TTOs in 174 institutions, up from 30 in 1979 (there are more TTOs today). He tracks their performance through 2012. Only 8 of these universities generated substantial revenue; most TTOs did not even cover staff expenses.

The danger is that no one will fund R&D.

So should states fund university research? The thrust of the Brookings project is that there are a lot of spinoffs. But to me the small number of winners (most patents come from a handful of metropolitan areas) suggest that it's good national policy but not good state-level policy – indeed Brookings work also shows that Federal R&D is more productive. That leaves open the question of who should fund "STE" (science-technology-engineering) training. The danger is that no one will fund it.

Note 1. Cf. Einstein's 1905 work on the photoelectric effect, which lies behind the xerox machine. The first patent drawing upon that did not come until 30 years later – Chester Carlson's first "electrophotography" patent of 1938, using a zinc plate and sulfur powder, not a selenium drum and carbon toner. Practical development did not start until 1946 and the first plain paper copier was not launched until 1959, though along the way the Haloid Corporation (later renamed xerox) developed specialized copiers for lithography and microfilms. [Photomultiplier tubes date back to 1934, building on a 1919 patent, and related experiments aimed at developing a TV camera using the photoelectric effect go back at least to 1926, so the "first" above is specific to copying technologies.]

Note 2. With a population of 316 million, we remain a large slice of the global economy even with the growth of China and Brazil and {hopefully} India and sub-Saharan Africa.

Note 3. Brookings claims that state R&D funding is increasing, Federal declining. See here. It's a brief note so provides no data, but outlines a version of the public good externality argument motivating this post.

Note 4. One anecdote – which is not "data" only an indication that exceptions exist – is flu vaccines. The underlying R&D was done at the University of Michigan (mea culpa: my brother worked in that lab for many years), and it continued to do the legwork of turning out the actual base vaccine, which includes various flu strains basic on work predicting which would be prevalent in the next flu season. Actual production was then handed off to commercial vaccine companies. When the head of the lab retired, it was closed and all work was transferred to outside commercial firms – none in Michigan. We as a society benefit enormously from that work, and likely most of the funding was Federal. But the commercial benefits didn't come back to benefit Ann Arbor, and private benefits are certainly not restricted to US citizens!

BK + Five Years

Automotive News has a retrospective with brief quotes from various participants. Let me briefly mention three that I found thoughtful despite the brevity imposed by the 2-page layout.

First, Mike Jackson of AutoNation notes the severity of the situation, with the possibility of a precipitous bankruptcy cascading across the economy: "We were at times within 24 hours of everything we knew being swept away." It is easy to forget exactly how dire things were, because of the interconnected nature of the supplier chain, and feed-on effects to the financial sector.

Second, John Krafcik, CEO of Hyundai American Motor, notes that car companies are wholesalers, so that when dealers stop buying cars, even at a comparatively healthy company "our cash flow began to get precipitously low" despite negotiating expensive one-off deals with banks to butress their position. But his snippet focuses on the interconnected nature of dealerships, as many of their 800 stores also had GM and Chrysler franchises. That parallel with the supply chain is easy to overlook.

Years back I read Krafcik's 1988 MIT master's thesis. He was a GM employee seconded to the now-shuttered NUMMI joint venture with Toyota, and coined the phrase "lean production" in a paper that later formed one piece of the 1990 IMVP book Machine That Chained the World.

Third, and not least is a short note by Shelly Lombard, an automotive analyst.

It wasn't really a surprise. It didn't mean the company wasn't viable, but it was just clear that this thing needed to be restructure. ... Companies don't go into bankruptcy because the earnings are bad. They go into bankruptcy when they run out of cash.

And of course "GM was blowing through cash" and [unlike Ford] had not mortgaged the company in advance of the crisis to create a cushion. "...so you knew the wheels were about to come off the car."

Mike Smitka

Data update: November 2013

Here are assorted data for your perusal – unfortunately due to the government shutdown data releases are delayed or (for certain data) a month will be skipped. For example, the "Employment Situation" was scheduled for November 1st; instead it will come out November 8th. Click on charts to expand to full size. – note that except for a large (negative) blip in the unemployment data, released after this post was written, it's more of the same. With the end of the government shutdown next month will likely see a rebound in the opposite direction.   

First, the first three charts on employment show a slow gain relative to age-adjusted population growth, but only slow. We still are far below normal levels of employment, and there's no particular reason to think that the fundamental structure of the labor markets and participation decisions changed over the course of a few months back in 2008-9 – no big shift in the ability to claim disability, no basic change in unemployment benefits, no change in wages [indeed, this recession reinforces the claim that wages are rigid downward, absent inflation], and I've already corrected the data for boomer retirement. That's clear if you look at the fourth chart of age-specific participation rates. Older workers – those of historic retirement age – are working more than ever [the chart gives data only from 2000, before then employment structures were relatively stable]. But in 2009 the share of people working in prime age brackets dropped, and that of younger people plummeted. Basically, while the economy is growing, it's not growing enough to eliminate the excess capacity of the Great Recession.

The fifth chart is investment. Again, we're out of the trough of 2009, but the level is still below that of some previous recessions. So more of the same: the economy is growing, but not recovering quickly.

That's not true for all sectors. As per the sixth chart, car sales have boomed; suppliers are at capacity, makers are having a hard time launching new vehicles at target levels of output. Still, we remain below the hyped level of the 2000s, and my sense is that sales are leveling out. There's still an overhang of vehicles from the go-go years, though depreciation operates far more rapidly in housing market. At the micro level I'm an example: since I'm stuck with an unsold house, we waited to replace our aging (240K miles 15 years) Volvo until the last minute – it wouldn't restart in the dealership parking lot so they gave me a tradein value lower than the local junkyard. We did buy a new car, as I judged the price differential relative to used cars too slim. However, too many people are underwater on their mortgages, median income [the point at which half the population has higher, half lower income] is falling. So my judgement is that the upside isn't going to move up very fast, despite our rising population. And while I only include the last couple years in the seventh chart, market shares have been relatively stable – with Toyota and Honda at a lower level. The eighth and final chart is of market groups. The top 4 firms have in the aggregate lost share, but over 2012-13 the Big Three and the Detroit Three have been stable.

Finally, interest rates have dropped back to the new normal under the Fed's antirecessionary monetary policy. With the fears of default eased, short rates are essentially zero. Now from day to day rates jump around, but remain extraordinarily low by historic standards, all the way out to 30 years. The yield curve is flat at maturities under 5 years, but there's now a moderately steep differential at longer maturities. With rates low, this isn't reflecting expected inflation but rather that eventually the economy will recover and with it short-term interest rates will rise. The market, however, is pricing that as years away – like 3-5 years. That is unfortunately consistent with my straight-line projection of labor market growth – at the current pace the gap won't be erased until the start of 2019. While I would not be surprised to see things accelerate as the housing stock normalizes ... well, the housing stock doesn't normalize quickly: according to the IRS, which is generous in such things, depreciation takes 30 years, and with median incomes stagnant, half the population isn't in a position to upgrade their "digs".

Date	1 month	3 mo	6 mo	1 yr	2 yr	3 yr	5 yr	7 yr	10 yr	20 yr	30 yr
10/15/13	0.32	0.14	0.16	0.16	0.37	0.68	1.45	2.11	2.75	3.50	3.78
10/16/13	0.14	0.10	0.11	0.15	0.34	0.64	1.41	2.06	2.69	3.43	3.72
10/17/13	0.01	0.05	0.08	0.13	0.33	0.61	1.35	1.98	2.61	3.36	3.66
11/05/13	0.06	0.05	0.08	0.10	0.32	0.60	1.39	2.06	2.69	3.46	3.76

Jay Alix Now Takes Credit for GM Bailout

Editor’s Note: Lots of people–including President Obama–have trumpeted their role in the success of the government-backed turnaround plan that saved General Motors, the most important industrial company in the history of the United States. But on the fifth anniversary of the crisis, Forbes presents an exclusive, unprecedented look at what really happened during GM’s darkest days, how a tiny band of corporate outsiders and turnaround experts convened in Detroit and hatched a radical plan that ultimately set the foundation for the salvation of the company.

Author Jay Alix, one of the most respected experts on corporate bankruptcy in America, was the architect of that plan, and now, for the first time, he reveals How General Motors Was Really Saved.

Ruggles Writes: Alix IS highly respected, or at least he has been. The country of Japan once paid him huge dollars to analyze their own economic system. But I am reading this article with a grain of sale. It seems to me to be somewhat self serving for a Johnny Come Lately to come in 5 years after the fact to take a large measure of credit. I'll try to follow up this post with documentation either for or against.

Steve Rattner mentions Alix Partners only once, on page 197 of his book "Overhaul." Regarding resentment of Team Auto's bankruptcy specialist Harry Wilson, who rubbed many at GM the wrong way, Rattner writes in the book:

"To hear Harry and his even younger aides imply that the company was slow, inept, and out of date was insulting, to put it mildly. "Who does this little prick think he is?" they would sometimes mutter after a meeting with Harry. But not everyone connected with GM responded this way. Longtime advisers from such firms as Morgan Stanley, Alix Partners, and Evercore generally nodded in agreement with Team Auto's requests and "prescriptions," which often echoed their own past recomendations to their reluctant client."

I had been told by numerous sources that Wagoner threatened to fire any GM employee who even whispered the word bankruptcy. Here's Alix saying the Section 363 sales was his idea, presented to Wagoner on December 8, 2008, days before the Bush Administration extended the bridge loans that allowed GM to survive until the Obama Administration came in to inherit the mess. It IS clear, however, that there had been many steps taken by Wagoner and his executive team leading up to the bankruptcy that helped facilitate the unprecedented 40 day walk through Chapter 11 bankruptcy court. Regardless, after presiding over about $80 billion in losses, Wagoner left GM in March 2009 with a substantial "Golden Parachute." Sources differ on whether he was fired by the President, Larry Summers, or Steve Rattner, or just offered to step down and had his offer accepted. His record at GM was mixed at best.

Forbes: October 2013

By Jay Alix

....

In the popular version of the company’s turnaround story, as GM teetered toward liquidation in 2009, an Obama-appointed SWAT team, led by financier Steven Rattner, swept in and hatched a radical plan: Through a novel use of the bankruptcy code they would save the company by segregating and spinning out its valuable assets, while Washington furnished billions in taxpayer funds to make sure the company was viable.

...

GM’s extraordinary turnaround began long before Wagoner went to Washington in search of a massive loan to keep GM alive. My involvement in that story began in GM’s darkest days, five years ago on Sunday, Nov. 23, 2008, when I visited Wagoner at his home....

“Filing bankruptcy may be inevitable, Rick. But it doesn’t have to be a company-killing bankruptcy,” I said. “I think we can create a unique strategy that allows GM to survive bankruptcy.” .... I proposed that GM split into two very separate parts before filing: “NewCo,” a new company with a clean balance sheet, taking on GM’s best brands and operations; and “OldCo,” the leftover GM with most of the liabilities. ...we would use Bankruptcy Code Section 363, which allows a company to sell assets under a court-approved sale. Typically, 363 is used to sell specific assets, from a chair and desk to a factory or division, but not the entire stand-alone company. Under this strategy GM could postpone filing a plan of reorganization and a disclosure statement, which consume months and fuel a blizzard of litigation while market share and enterprise value bleed away.

... I volunteered to help GM on a pro bono basis. But what I could never anticipate was how deep and strong the opposition to my plan would ultimately be.

On Tuesday, Dec. 2, I pulled into GM’s Detroit headquarters at 7 a.m. after most of the company’s executives had already arrived for work. I was given a small cubicle and conference room on the 38th floor, a spacious but empty place that held GM’s corporate boardroom and a warren of cubicles reserved for visiting executives and board members.

Spending 18 hours a day digging through the numbers in GM’s filings, I began working in greater detail on the outlines of the plan and making some assumptions on what assets should be transferred to NewCo and what would stay in OldCo, which I dubbed Motors Liquidation. There were thousands of crucial questions that had to be asked and answered with management: Which brands and factories would survive? Which ones would the company have to give up? What would be the endgame strategy? What would be the enterprise value of NewCo? The liquidation value of OldCo?

...three alternative plans. First, they hoped to avoid bankruptcy altogether, believing the government would provide enough funding to bring GM through the crisis. At least two cabinet members in the Bush Administration and others had provided assurances to Rick and board members that government help would be forthcoming.

Second was a “prepackaged” bankruptcy plan being developed by general counsel Robert Osborne with Harvey R. Miller, the dean of the bankruptcy bar and senior partner at Weil, Gotshal & Manges. Under this plan, GM would prepare a reorganization in cooperation with its bond creditors that would take effect once the company went into a Chapter 11 bankruptcy. The goal of a so-called prepack is to shorten and simplify the bankruptcy process....

And third was the NewCo plan, based on years of experience at AlixPartners, where we had a major role in 50 of the 180 largest bankruptcies over $1 billion in the past 15 years. GM had also retained Martin Bienenstock, the restructuring and corporate governance leader from Dewey & LeBoeuf, to help develop the NewCo plan as well....

From my perspective Wagoner had been unfairly treated by many politicians and the media. Since taking over as CEO in 2000, working closely with Fritz and vice chairman Bob Lutz, Rick orchestrated large, dramatic changes at the company. They closed GM’s quality, productivity and fuel-economy gaps with the world’s best automakers, winning numerous car and truck awards. They built a highly profitable business in China, the world’s biggest potential car market. They reduced the company’s workforce by 143,000 employees, to 243,000. They reached a historic agreement with the UAW that cut in half hourly pay for new employees and significantly scaled back the traditional retiree benefit packages that had been crippling the company, while also funding over $100 billion in unfunded retiree obligations. And he was able to accomplish all these changes without causing massive disruptions among GM’s dealers or major strikes with the unions.

Ultimately, those structural changes positioned the company not only to survive but also to bring about the extraordinary turnaround. But now, with the economy and the company in free fall, all of that hard work seemed to be forgotten.

....

“Rick, do not resign ... until we get the three things...

“We have to get government funding of $40 billion to $50 billion. Plus, we need an agreement with the government and GM’s board to do the NewCo plan. And we must put a qualified successor in place. It must be Fritz and not some government guy. It’s going to be painful for you, but you’ve got to stay on the horse until we get all three.”

When we gathered for a telephonic board meeting on Dec. 15, the mood was urgent, the tension high. Only two weeks after arriving at GM I was about to present the plan to the board of directors in a conference room outside Wagoner’s office. Also on the phone were the company’s lawyers and investment bankers.

... we were just two weeks away from running out of cash.

Miller [and] ... Other attorneys chimed in, claiming the plan oversimplified the situation and there would be major problems with it. Yet another added that this would not be viewed well by the court and doubted any judge would allow it. Collectively, they characterized it as a long shot, discouraging the directors .... Unbeknownst to me [inside counsel] had previously proposed the idea to GM’s board, naively believing GM could complete a prepack bankruptcy in 30 days....

... Kent Kresa, the former CEO of Northrop Grumman and a GM board member since 2003 [spoke:]

“I understand this has some risk attached to it, but we’re in a very risky state right now,” he said. “And I understand it may even be unusual and unprecedented. But it’s certainly creative, and quite frankly, it’s the most innovative idea we’ve heard so far that has real potential in it. I think it deserves further consideration and development.”

Rick then addressed another lawyer on the call, Martin Bienenstock.

“Well, I’ve actually studied the problem, too, and there’s a way for this to work,” said Bienenstock. “Almost all bankruptcies are unique and the Code does allow for the transfer of assets. I can’t imagine a judge taking on this problem and not wanting to solve it. We’ve done a preliminary analysis, and it’s not as crazy as it sounds. It’s unique and compelling.”

“Okay, we’ve heard both sides of it,” Rick said after others spoke, smartly bringing the debate to a reasonable close. “I suggest we continue working to develop both the prepack plan and the NewCo option, while seeking the funding to avoid Chapter 11 if at all possible.”

The meeting adjourned without a vote....the next weeks I worked closely with Bienenstock, assistant general counsel Mike Millikin, Al Koch of AlixPartners and GM senior vice president John Smith on the NewCo plan. We huddled dozens of times with Wagoner and Henderson to work out which brands GM would ultimately have to give up (Hummer, Saturn, Saab and Pontiac) and which ones it would keep (Chevrolet, Cadillac, GMC and Buick). Informed debate and deep analysis of structural costs led to decisions about projects, factories, brands and countries.

On Sunday afternoon, Mar. 29, Wagoner called me. It was a call I had hoped would never come–but here it was. ...

Wagoner told me Henderson would be named CEO. “What about the bankruptcy?” I asked. “They’re enamored with the 363 NewCo plan. They seem bound and determined to make us file Chapter 11 and do NewCo. … This is really tough,” he said.

“I’m so sorry,” I said, pausing, “but … you got the money. They’re doing the NewCo plan, and Fritz is your successor. … You’ve succeeded. You got the three things.” ....

.... The strategy I pitched to Wagoner in his living room four and a half months earlier was the plan chosen by Team Auto in a meeting on Apr. 3, 2009 in Washington. Treasury agreed to fully fund NewCo with equity, and thus it became the chosen path to save the company.

[...and more on subsequent events]

Mike Smitka: As per Ruggles, this is fascinating, though as Ruggles points out none of the various insider accounts mention Alix as the source of the idea, though (I checked) contemporary news accounts do credit him and the others he mentions as outside advisors to GM. My suspicion is that the Task Force had staff who independently considered §363 – a quick news database search found lots of references in fall 2008 to §363 bankruptcies of this sort, including a panel at a bankruptcy lawyer conference labeling it a "hot topic". Similarly, on 20 February 2009 the WSJ blog [Deal Journal] posted of a Heidi N Moore interview with Mark Roe of Harvard Law School suggesting it as the obvious approach. In any case, both their performance in public and Rattner's account of interactions in private cast doubt on the ability of GM's finance operation to pull together details, and the sub-text I read in the Alix story is that until the very end GM's board remained fixated on unrealistic scenarios. Alix however focuses on Wagoner and does not point out that most of the board was replaced. But the latter deserves a post of its own, moribund boards of moribund companies. Chrysler under Iaccoca, GM under Roger Smith, Nissan for the 20 years prior to its acquisition by Renault...there are all too many examples.

Transparency and the Retail Auto Business

The new buzz word in the Auto Industry these days is “Transparency.” Auto manufacturers have fallen in  love with the word, as have vendors looking to charge Dealers money to bring "Transparency" to their customers. To some, the word is euphemism for “One Price,” where every buyer pays the same profit margin.  This has been proven to be an abject failure. The demise of the Ford Collection is the prime example.  We could revisit the Saturn debacle, but why? How many times does the lesson have to be learned. Does anyone actually think Saturn was a success story?

There are still Dealers using “One Price” as a strategy of Negotiation, but “One Price” ONLY works when there is more demand than supply. Most Dealer’s fantasy is to wake up one day and find out that his nearest competitors have all gone to a “One Price” strategy.

To many consumers, "Transparency" means being able to bypass the dealer and buy direct from the manufacturer so everyone pays the same margin and there is no middle man profit.  After all, they aren't aware there really is no middle man profit, on average, after payment of middle man expenses. For some reason, they are oblivious to the fact that those expenses still exist if the factory owns the car dealership.

Ever notice how it is the Silicon Valley types who want to change our business? Ever notice that they have never sold cars on commission or owned a Dealership before they set out to give Consumers what they think they want. These people are experts at running focus groups, although they don’t know the right questions to ask or how to interpret Consumer answers.

So lets set out to thoroughly discuss the issue of “Transparency” as it regards the Car Business.

“In economics, a market is transparent if much is known by many about:

1. What products, services or capital assets are available.
2. What price.
3. Where.

There are two types of price transparency: 1) I know what price will be charged to me, and 2) I know what price will be charged to you. The two types of price transparency have different implications for differential pricing.

A high degree of market transparency can result in disintermediation due to the buyer's increased knowledge of supply pricing.

In economics, disintermediation is the removal of intermediaries in a supply chain, or "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate (such as a distributor, wholesaler, broker, or agent), companies may now deal with every customer directly, for example via the Internet. One important factor is a drop in the cost of servicing customers directly.

This can also happen in other industries where distributors or resellers operate and the manufacturer wants to increase profit margins, therefore eliminating intermediaries to increase their margins. (In the case of the Auto Industry, the “intermediaries would the franchised new vehicle Dealers.)

“Disintermediation” initiated by consumers is often the result of high market transparency, in that buyers are aware of supply prices direct from the manufacturer. Buyers bypass the middlemen (wholesalers and retailers) to buy directly from the manufacturer, and pay less. (Buyers can also pay MORE because the manufacturer controls the market. Competition between Dealers is what maintains the price equilibrium Consumers aren’t smart or knowledgeable enough to appreciate.)

Price transparency can, however, lead to higher prices, if it makes sellers reluctant to give steep discounts to certain buyers, or if it facilitates collusion.” Excerpts from WIKI

In legal terms, and in the context of the Auto Business, “Transparency” means fully disclosing all information mandated by all applicable laws in exactly the way the law demands these disclosures take place. There is NO legal mandate that the Consumer has to be happy with the transaction. We have always known that a “Good Deal” is largely a state of mind.]

Definition of “NEGOTIATE,” Merriam Webster:

1. to confer with another so as to arrive at the settlement of some matter.
2. to deal with (some matter or affair that requires ability for its successful handling):
3. manage to arrange for or bring about through conference, discussion, and compromise “

More WIKI Excerpts

A brief historical reference of Transparency Regulation in the context of the Auto Business:

New vehicles did NOT have a stated and posted price until 1958, when a law sponsored by Senator Mike Monroney of Oklahoma was passed. Trucks did not have a priced Monroney label until much later. “The window sticker was named after Almer Stillwell "Mike" Monroney, United States Senator from Oklahoma. Monroney sponsored the Automobile Information Disclosure Act of 1958, which mandated disclosure of information on new automobiles.”

Even if the Consumer is prepared to pay the Auto Dealer’s asking price, the value of any trade in has always been a matter for Negotiation. There is no single wholesale value for any Pre-Owned vehicle. A vehicle is worth whatever a wholesale Buyer will pay at auction in a competitive bid situation on a given day. Typically, Retail Buyer’s want Retail for their trade, thinking the Dealer should sell their trade at Retail just to get their money back, for the privilege of selling a new vehicle.

Even in the most simple purchase situations, where a Dealer states his/her price and the Buyer accepts and makes the purchase, this is still technically a “Negotiation.” The stating of a price is a first pass of Negotiation. Regulation, beginning with the government mandated Monroney label, has forced Dealers to state their price instead of merely entertaining offers on sales. The Monroney law came into being after WW II, when Auto Dealers, who hadn’t had new vehicles to sell for years, were in a short supply, low demand situation. And they took advantage. After all, they had just been through a period of no supply and high demand and had previously experienced high supply and low demand during the Great Depression. Consumers were offended, preferring only to experience a market driven by higher supply than demand.

As a practical matter, it makes no sense for a Dealer to debate “transparency” with Consumers OR with those who have never had the experience of making a livelihood by selling vehicles or with those with a major investment in an Auto Dealership. They have no standing on the issue. In the Auto Business it becomes clear quickly that without substantial gross profit, one doesn’t eat very well. The Sales Person’s welfare or the Dealer making a profit are NOT concerns of most Consumers. Consumers typically have no understanding of what a Dealer’s Cost of Sales might be. They don’t typically care. But for some reason many Consumers think they have the right to know a Dealer’s cost structure. These same Consumers seldom ask cost and margin questions of other retailers. At the least they don’t want to pay more than other Buyers of the same product. That’s no surprise. Neither do I. But if I buy from a “One Price” Dealer there is NO ASSURANCE that others aren’t buying for less than I do. After all, there are always competitive Dealers who are happy to work from their “One Price” competitor’s Best Price.

All car buyers negotiate in some fashion and to some degree. Car buyers typically think they are entitled to be quoted a price to take to competitive Auto Dealers. The first Dealer either accommodates, or doesn’t. If the Buyer doesn’t like a Dealer’s Negotiation Strategy, they are free to find one that gives them what they want. In other words, the market works in the Buyer’s favor. The Car Buyer can find another Dealer more quickly than the Dealer can find another Buyer. Consumers are NOT held to the same laws and ethics that Dealers are obligated to. So the Consumer holds all of the advantages, EXCEPT, in most cases, the Dealer has more experience Negotiating car deals and possesses more accurate information. Providing equal information to a Car Buyer would, in theory, create an efficient market that could commoditize new vehicles. This could theoretically eliminate Dealers. But then who would take the trades? Who would arrange the financing? And who would teach Consumers how to interpret all of the information?

In Business, it is also clear that if a Negotiation takes place, and neither party gets their “feathers ruffled,” someone left money on the table.

So what do Car Buyers really want? They want a guarantee that they will WIN the Negotiation. They want a guarantee that the Dealer will quote them a price that they can validate in their own mind by using what the first Dealer provided to shop other competitive Dealers. This has not changed in my 43 years in the Auto Business. Only the method of delivery of the information has changed, as well as they ease with which a Consumer can shop. If a Dealer doesn’t play along, they are vilified, not only by Consumers, but OFTEN by 3rd Party Vendors who appeal to Consumers and who also depend on Auto Dealers for revenue. But the Market works. If Consumers are unhappy with one Dealer, they can go to the next. They can also make use of information provided by the Vendors, although these Vendors are at risk if they also depend on Dealers for revenue.

As it involves the varying definitions of “Negotiation,” many Car Buyers would prefer to have the Dealer disclose the triple net cost of their product, and then “Negotiate” the “Margin.”

So how does one sell New Vehicles in this environment? Most Dealers attempt to provide Consumers with a “Perception of Transparency” as a Negotiating strategy, since TRUE Transparency would prevent making a Gross Profit high enough to pay overhead expenses. We currently do not have true Transparency and we are still seeing considerable margin compression.

The Consumer has the ability to shop until they find an Auto Dealer Negotiation strategy they like. Some give up and buy because they were worn down, lost patience, and gave in. Others depend on the Dealer to arrange financing which may be more important to them than the price of the vehicle.

Despite the massive amount of regulation that has been imposed on the Retail Auto Business, the current Market Driven system has sold up to 17 million vehicles in a year. Some might say the system has served us well over the years despite the fact that many Consumers are aggravated by the process. To those Consumers, I say, “Keep shopping until you find the Dealership shopping experience that gives you what you want.” Let the Market work.

Dealers are not typically completely “Transparent” with their own Sales People and Managers. Why should they be? It is human nature for Sellers to give away potential profit in an effort to make a sale. The cost structure of a new vehicle is so complicated that even Dealership management staff has a hard time understanding it. In many cases, the true cost structure is not determined until a Dealer receives a check based on the achievement of objective over a period of months. With all of the possible incentives, including “Conquest Incentives, “Realator Incentives, Plumber Incentives, Glass Company Incentives, First Time Buyer Incentives, Fleet Incentives, Special Bid Incentives, College Grad Incentives, Employee Purchases, various “Private Offers,” Returned Military Incentives, and many more, plus variations of the above. Trying to provide all of this information, including teaching Consumers the elements of the wholesale market would be overwhelming to most. It would be akin to drinking from a fire hose. There is a considerable learning curve when training new Sales People. Consumers aren’t typically going to understand it all when they are only buying a vehicle every few years.

New hires entering the Auto Business as Sales People bring their perceptions as a Consumer to their new job. Like me 43 years ago, most were convinced in the beginning that selling cars would be easy. All one would have to do is to quote the lowest price and make up the loss of margin in additional volume. What a revelation us veterans of the business had when we found out that Consumers had no loyalty. There has never been such a thing as the “best price,” despite the fact that Consumers typically think there is. As an early “price quoter” I was the one who spent the time, gave a detailed product presentation and demo drive, only to find many of my prospects, who had promised to “Be Back,” had bought from a competitor who had beaten my “Best Price” by a small margin. Occasionally, deals are lost because one appraiser might see more value in a trade in than another.

To be clear, some Auto Dealer attempts at negotiation are more “artful” than others, and crude attempts at Negotiation generally fail. The Consumer isn’t harmed, except for some wasted time. They are certainly given “grist for the mill” in their complaints about “Negotiation.” They are free to keep shopping for that Dealer who gives them what they seek. But then some Consumers are never satisfied.

I recall a time when my boss, the Dealer himself, quoted me a price that involved a $1K mistake in my Customer’s favor. I presented this price to my Customer who then railed about us being crooks, cheats, and liars. After shopping our quoted price the Customer later slunk back into our Dealership to take try to take advantage of the mistaken quote. And because we didn’t honor the price from two days earlier, we were crooks, cheats, and robbers all over again. A good deal is as much perception as reality.

Let’s discuss “Transparency” as a practical matter in the modern Internet driven Auto Market. The most demanding Consumers are the ones who have 720 and higher credit scores. They know they have good credit and can buy what they want. They are the ones who are most analytical and the most demanding of information to shop with. They are the ones who feel most entitled to be able to determine the “Best Price” from the convenience of their office chair using the Internet, entertain competitive quotes from Dealers all vying for their business, and to make a purchase decision without spending a lot of time or going through a more traditional process of negotiation. They will typically visit a dealership for a demo drive and to gather additional information, then retreat to their computer to use the Internet to “Negotiate” the price as they try, often successfully, to get Dealers into a bidding war with each other. The fact is, this niche of Buyers make a LOT MORE NOISE than their numbers would indicate. This group makes up LESS THAN 30% of Consumers. And of that 30%, at least 5% of those have a debt payment to income ratio that does NOT guarantee them financing. All other Car Buyers have a legitimate concern that they might not gain credit approval for a Car Loan at optimum terms and interest rates. AND without the help of Dealers and their market power, many of these could NOT gain a car loan on their own. Does anyone with common sense believe that the Retail Auto Industry should turn itself upside down over 25% percent of Consumers who represent less than 15% of total Vehicle Sales Gross Profit?

In this current environment Manufacturers are coercing Dealers into ever higher overheads through ridiculous “Image Programs.” What happens if margin compression makes the selling of vehicles unprofitable to Auto Dealers? A quick look at history will give an indication. When I entered the auto business in 1970, the Markup on large vehicles was 22.5 percent, plus a 2 – 2.5% “Hold Back” that was paid to the Dealer every quarter or at year end. Imports typically had no “Hold Back” in those days. Deals were transacted OVER “Invoice,” the amount the Manufacturer drafts the Dealer’s floor plan account when the vehicle leaves the assembly plant, sometimes before. There was little “Trunk Money,” money rebated to the dealer based on “Stair Step” programs and other incentives based on achievement of an assigned objective. In other words, “Invoice” had meaning. Today “Invoice” has little meaning. Consumers routinely take delivery of a new vehicle for LESS than the Dealer has to pay off at his/her lender. The “Markup over invoice today is less than 10%. Manufacturers have raised the MSRP to accommodate both the cost of rebates and subventions, but also the “Trunk Money.” In 1970 F&I revenue represented a relatively small portion of Gross Profit on a per deal basis. Today the per deal F&I gross profit runs from $1K to $1.5K. Labor rates in Dealer Service Departments were reasonable in 1970. Today, $100. plus per flat rate hour isn’t unusual. Are you starting to get it now?

Many Consumers think Manufacturers should cut their Franchise Dealers out of the equation. First, there are laws in place to protect those Dealers, all of whom have made substantial investments in their businesses. Secondly, the OEMs would need Ben Bernanke's printing presses running full time to ever come up with the amount of capital required to replace their Dealers. It ain't gonna happen.

The Bottom Line:

1. Consumers already have the market slanted in their favor
2. Consumers can readily shop
3. If Consumers don’t want to “Haggle,” let them find a Dealer who will give them what they want.
4. Vendors who started their businesses depending on dealers for their initial revenue, and who now turn on those dealers and demonize them in an effort to convince consumers to turn to them for “protection” from the villains, and who provide even more downward pressure on gross profits, can expect push back and a lack of cooperation from auto dealers.

TrueCar, CarFax, Cars.com, and some others have paid a price for pushing Dealers too far by providing Consumers additional tools to help them in the effort to compress margins, often depending on Dealers to support their efforts. These Companies have every right to do what they are doing and/or have done, but they are unrealistic if they expect there to be no push back from Dealers. I suspect there are some others, including Kelly Blue Book and their version of the “Bell Curve, recently abandoned by TrueCar while under fire from Dealers, who will be a target for Dealer push back.

As long as the Franchise Dealer system is in place, trades are taken, and financing not a given, there will be no completely “Transparent” and “Efficient Market” that commoditizes pricing in the Retail New Vehicle Business. Is this a surprise, or just common sense? The current system has served us well and will continue to do so.

At the recent JD Power/NADA conference held in March in New York City, noted Auto Industry analyst Maryann Keller spoke optimistically about the conventional system of selling cars in the U.S. “Over four decades, I’ve heard many arguments made against the Franchise Dealer system.” They are claims Dealers never fail to disprove time and time again.”

One myth promulgated in the 1990s, and now resurfacing with Tesla’s effort to run its own sales outlets, is that factory stores save money by reducing distribution expenses, wrongly estimated at 30% of the total cost of a car.

Put aside for a moment that the percentage itself is way off, Keller says. Ford’s ill-fated Auto Collection experiment in certain markets during the late 1990s proved that Auto Companies are good at a lot of things. Running Dealerships isn’t among them. Dealers with entrepreneurial spirit are good at doing that.

Ford ended its bad-science experiment after a couple of years of market share losses and mounting evidence that Factory Stores do not deliver a better customer experience nor reduce costs.

Franchise dealers’ cumulative investment in land, equipment and facilities easily exceeds $100 million, Keller says.

“Dealers fund 60 days of inventory and another month of inventory in transit that would otherwise fall to the Auto Maker.”

The inventory buffer allows auto makers to adjust future production levels. For a company like Ford, U.S. inventory funding equals about $15 billion at any point.

“While we are talking about myths, how about the still-repeated one that people hate Dealers so, if given the chance, they will buy a car online,” Keller says. “I almost don’t know where to start in taking this one apart.”

Not all that long ago, Silicon Valley funded and lost hundreds of millions, maybe even a billion dollars, on ill-fated ventures that promised to sell cars online.

“CarOrder.com, Greenlight.com, and CarsDirect.com (in its original configuration), among others, all promised to avoid the dealership experience,” Keller says. “A few actually did that by buying cars from Dealers, and then reselling them at lower prices to customers until they blew through their capital.”

She recalls the defunct Build to Order.com. It proposed that customers would place orders for fully customized cars while lounging in a company-owned showroom/entertainment center. “Build-to-order.com never built anything for anyone,” Keller says. Priceline.com’s experiment of trying to sell cars online was in some respects replicated later by TrueCar.com, which ran afoul of franchise laws for the same reasons Priceline

“What I learned then, and this is still true today, is that we could connect Buyers with Dealers and that the price of a vehicle was the easiest part of a deal,” Keller says. “The other elements are harder to control and often the cause of frustration for the Customer and the Dealer. People don’t like to hear that their trade isn’t worth the value they saw online or that their poor credit doesn’t qualify them for the no-down-payment, 0% loan.”

Buying a car is as complex as buying a house, Keller says. “Why should we think it should be as easy as buying a pair of shoes from Zappos with a return receipt in the box in case they don’t fit?” While much Auto Advertising has shifted from newspapers to the Internet, that transition “has not reduced Advertising expense per vehicle or made buying a car as easy as buying a book,” she says.

Another salient Keller point:

“Add up all the monthly traffic to all automotive sites, including auto makers, dealers and independent sites, and you’d get more than 100 million, possibly close to 200 million, unique visitors using the Web to get information about buying or selling a new or used car.

Except there’s one problem, if this traffic is somehow supposed to represent potential sales.” Dealers retail about two million new and used cars a month. That’s a fraction of all those automotive website visitors.”

“So just like newspaper, radio or TV advertising, Dealer spend on the Internet is likely no better targeted, once again dispelling the notion that the Internet would solve the age-old problem of knowing which 50% of a dealer’s advertising works.”

Technology is wonderful. Dealers have adapted to it. Sophisticated software helps them manage every aspect of their business. But it will not fundamentally change Auto Retailing, Keller says.

“The system of Franchised Dealers – using their own risk capital to fund their businesses and guarantee millions of dollars of inventory, promote their own brand and that of their OEM, provide the expensive tools needed in their service departments, and manage the endless headache of a workforce – will not be superseded by technology or Factory Owned Mall Stores.”

Keller predicts start ups such as Tesla, which currently runs factory-owned mall stores, ultimately will conclude “the dealer network is the best way.”

I would only add this. As long as Auto Makers understand that Dealers are their Customers and the End User is the Dealer’s Customer, things will be fine.

david ruggles