Valuations
Valuations
By
Tino Rossini
April 28, 2008
Copyrighted
Preface
From the early 1970’s I have been actively involved in all aspects of leasing cars and trucks.
I remember the early leases being what we call walk away leases today, inspecting lease returns, calculating leases, doing credit applications and investigations.
We were doing what would be understood today as a full service lease, the lessee paid a monthly fee and with the exception of gas everything was included in the lease payment including insurance. It enabled the lessee to know the exact cost of the vehicle on a monthly and yearly basis.
Today there are fleet management companies that still do what we were doing 35 years ago. It seems that some things never change.
In 2008 most leases are walk away leases and they are primarily a financial instrument that improves to affordability of a vehicle. Especially for higher priced vehicles leasing has been a powerful financial lever for many years.
In the early days of leasing setting a residual was as simple as asking what a 3 year old comparable vehicle is worth today…presto a 36 month lease residual was established.
In contrast to today they were simple times with limited technology where the human brain was the computer.
Evolution of Leasing
Leasing has evolved and morphed into several different forms through the years, especially during the last 10 years in Canada where it has gained increasing popularity.
The automotive business is cyclical, and leasing has gone through a few cycles of its own especially when there is a slowdown in the economy, or prices are altered for one reason or another.
A well structured and crafted lease is a powerful financial and marketing instrument for the manufacturer, the financial service company, the dealer, and the lessee (customer). It’s a win-win-win-win situation for everyone.
In the old days…is there such a thing as old days…in years gone by…a lease afforded a higher degree of customer control, and an assured level of lease returns that the dealer could resell as used vehicles.
At the same time leasing was misunderstood since car ownership exuded a strong sense of pride…who remembers pride of ownership. I remember criss crossing Canada on a few occasions to influence dealers of a specific manufacturer to offer leasing since it would increase their sales and obvious those of the manufacturer.
As leasing gained in popularity it increasingly became a competitive lever, needless to say that every manufacturer and every financial service company usually a captive of the manufacturer embarked on a mission to gain a competitive advantage through leasing.
Since leasing comprises several variables, its easy to tweak the variables, and attempt to gain an additional advantage. Technology was an immense facilitator to analyse and fine tuning the various variables.
A glimpse into the start of leasing
In 1939, Zollie Frank, a car dealer in Chicago, suggested that Petrolager lease five automobiles for its salesmen instead of purchasing them. The benefits were twofold . Petrolager would retain control of the vehicles and also avoid large cash outlays. Petrolager agreed, and soon afterward Frank and his brother-in-law Armund Schoen founded the Four Wheels Co., which many in the industry identified as the first automobile leasing company. In 1954, the company became known as Wheels, Inc. It remained one of the largest fleet management companies in the United States in 1997 with more than 160,000 automobiles under lease.
Affordability
Leasing gained in popularity when the lessee (customer) grasped that a lease improved the affordability of a vehicle, and conserved cash that could be used for other activities or investments.
The saying was “Buy what appreciates, lease what depreciates” and everyone knows that vehicles depreciate. Especially that for a certain period leasing was denigrated as the financial instrument for folks that could not really afford the car.
As everyone concerned increasingly understood that leasing improved the affordability of vehicles, especially the more expensive vehicles. Leasing gained momentum and with time evolved from improving affordability, to literally how affordable can it get.
In Canada where vehicles have always been more expensive and consumed a larger share of the individuals income. Leasing soon became the instrument of choice to enhance the affordability of vehicles.
Creativity
If leasing sells more vehicles by making them more affordable, if one is creative one should be in a position to sell even more vehicles. Human nature being what it is, with folks looking to further their careers, empowered by various forms of technology, facilitated by consulting firms that specialise in predicting the future.
What was a lever to improve affordability, morphs into a lever to steal business and customers from the competition, to gain market share, to deliver more vehicles, to control and increase the loyalty of customers.
Lets be creative to lower the monthly payment. Lets be creative to steal customers from the competition, lets be creative to control the existing customers, lets be creative to uphold values.
Is it starting to sound like too much creativity?
New Age
This creativity presented with power points, supported with spread sheets and guided by various consulting services quickly created a New Age Lease Think.
Similar to the dotcom frenzy in which the laws if gravity for a fleeting moment do not apply.
In Canada the last major lease challenge was in the early 1990’s and by the early 2000’s it was conveniently forgotten as something that would never reoccur. Many of the new age thinkers were not around in the early 1990’s to remember anything, and obvious that these new age thinkers would not pay attention to individuals that were around during previous challenging times.
Initially the new age thinkers start tuning and tweaking the various components and variables at the inception of a lease…to get the prospective customer in the showroom.
Subsequently the new age thinkers initiate a process to tweak the back of the lease…which is the lease return and how to maximise the values of lease returns.
For a period of time the various planets line up in favour of the new age thinkers its all working smoothly …why didn’t we do this before. We have a good thing going here…we are moving metal like there’s no tomorrow…we will keep on moving more metal like there’s no end in sight.
It starts getting somewhat precarious when New Age Lease Think start defying gravity.
Money
A lease improves the affordability of a vehicle since only half of the vehicle is converted to money with the first customer. Contrary to a purchase where the entire vehicle is converted to money, and changes ownership.
With a lease the ownership remains with the financial service company / manufacturer which in most instances involves increased risk for the manufacturer and the captive finance company.
Retail finance appeared many years ago to facilitate the conversion of a vehicle to money and new ownership…retail finance from a captive company came about since at the outset of the automobile most banks refused to lend money for the purchase of this new invention called the automobile.
Leasing appeared as a service to facilitate the acquisition of vehicles. By leasing companies limited the cash outlay for vehicles, and financially participated in the shortcomings if the agreed residual value was not recuperated at the end of the lease.
When any vehicle is leased it’s a 2 step process to convert it to money, this process has never changed through the years its always been 2 steps one at the inception and one at the termination of the lease.
The first step at the inception of the lease is relatively simple, creates excitement, generates immediate results…the vehicle is delivered to a customer.
The second step at the termination of the lease is more important, not as glamorous, and can become a perilous and risky process.
Lease Variables
A lease is comprised of several variables that can be altered, fine tuned, and adjusted to make a lease responsive to current market conditions, and demands.
The variables with the most impact and the biggest influence are the initial price and the residual value of the vehicle.
In Canada the initial price was relatively high, since the valuation of the Canadian dollar was low. The residual value being calculated as a percentage of the lease initial price (MSRP) its goes without saying that a high initial price generates a high residual value.
A low Canadian dollar created a robust export market from Canada to the US which facilitated the sale of lease return at residual values or higher. If the low Canadian dollar created a higher prices it also empowered an export safety net to uphold values.
This was a favourable landscape for “customer leasing of vehicles” prices were high, residuals were high, the Canadian dollar was low, the export market was very active. More important the customer was getting a good deal.
The various variables were in a state of balance which lasted for a few years, with leasing became more popular, and gaining increased momentum.
Empowered by technology its easy to run several “what if “ scenarios to constantly fine tune variables of which residual value exerts the most dramatic influence on the lease.
Residual Values
To verbalise the concept of lease residual values is easy, more challenging is to have an in depth understanding of what it takes to convert a residual value to money.
Years ago a residual value which is a lease return in many instances had “equity” at the termination of the lease. The market value of the vehicle was higher that the lease residual value.
Setting residuals has evolved from a seat of the pants gut feel process to a science with a choice of analytical tools to justify and corroborate the decisions in establishing residuals.
Since the residual has a dramatic effect the monthly payment of a lease, accompanied by the positive experience of the recent past, there is a strong motivation to set aggressive values to gain a market advantage and move more vehicles.
In a market context where the actual cost has been camouflaged to the customer for several years. If a stand alone lease improves the affordability, an subsidised lease can gain market share, then a lease on steroids (subsidised and aggressive residual) can do wonderful things in the market.
Manufacturers are competing on the initial lease terms, and on the residual values to gain a market advantage. Often taunting each other by mentioning the strength of their residual values which gives them the ability to offer better lease deals (lower monthly payments).
The customer is offered exceptional deals, and in many instances quickly realises that the lease terms are “ambitious” and somewhat detached from gravity.
The manufacturer and the captive finance possess hard drives full of information and analysis to justify the residual values that are established. If by chance there is a discomfort, side agreements between the manufacturing arm and the finance arm of the manufacturer establish a level of comfort and shared risk.
Popularity of Leasing
The Canadian customer has understood that its easier to lease a vehicle for a set period of time, not be bothered with any issues that might arise from the vehicle, then walk away from the vehicle and start with a new one.
Leasing experiences a snowball going downhill effect, its very successful in Canada. Leasing penetration is at 50% with even higher percentages for the more expensive vehicles.
Lease returns are increasing with the wholesale infrastructure quickly adjusting and offering services to convert lease returns to money. The entire system can deal with converting lease returns to money.
It’s a good thing lets keep on leasing.
Converting the Lease Return to Money
There is a sophisticated system in place to convert lease returns to money at the wholesale level. The captive finance companies can quickly and efficiently convert their lease returns to money to recoup the established residual value.
Its an incredibly efficient system, a thing of beauty to watch it function and generate results.
Without technology this system could not operate with such efficiency…it’s a fully empowered system to convert lease returns to money at the wholesale level.
Its also a system where the manufacturers and the captive finance companies are the sellers.
Brief Summary
Lets stop for a moment and review the ground that we have covered so far…
In Canada leasing improves the affordability of vehicles, the high prices from the low value of the Canadian dollar were mitigated with the use of leases, the Canadian customer never endured the full reality of high prices.
If leasing improves affordability, subsidised leasing is a robust lever, and leasing on steroids is a powerful weapon in a tactical arsenal to move iron.
The ability to export vast quantities of used vehicles facilitated the conversion of lease returns to money at the wholesale level which bolstered the values of used vehicles in Canada.
The New Age Lease Think empowered by technology and consultants explored every variable of a lease to grasp the last gram of advantage to move more vehicles at the inception, and protect the residual value at the termination of a lease.
The customer that opts to lease a new vehicle in most cases receives exceptional value for his money.
As these vehicles become lease returns at the termination, the disposal system gears up and empowers itself with technology to quickly and efficiently process vast numbers of these vehicles and convert them to money at the wholesale level.
The same New Age Lease Think that is applied at the inception of a lease, is applied at the termination of a lease to convert the residual value to money at the wholesale level.
This New Age Lease Think works well until there are low to medium hanging fruits that can be reaped both at inception and termination, and the established order of things does not get altered by exterior forces or events.
Certified Pre Owned
Manufacturers well aware of the increasing number of lease returns and the often lack of desire from their franchised dealers to handle lease returns. Accompanied by the need to ensure that residual values are upheld, along with a desire to exert control on the used market for their brand of vehicles.
Suddenly a new manufacturer emerges on the automotive landscape…The Certified Pre Owned Corporation of fine inspected used vehicles.
It’s a concept that had been entertained for countless years to motivate franchised new vehicle dealers to become active with used vehicles.
Implementing a manufacturer supported system to enhance to value and credibility of used vehicles from the perspective of the customer is a good thing especially if it facilitates converting lease return to money at the dealer / retail level.
It follows that if the new vehicle is offered with a steroid lease, its only a question of time before the Certified Pre Owned Corporation starts offering steroid lease on their used vehicles.
After an initial period of success the Certified Pre Owned which has a positive perception from the customer, starts diluting vehicle values.
A Few Thoughts
If new vehicles are offred with leases on steroids and actively compete with used vehicles what will it take to retail used vehicles?
If lease returns are converted to money at the wholesale level with franchised and independent dealers actively bidding it’s a good thing.
If franchised dealers subsequently get a “steroid package” from the manufacturer and captive finance company to expedite the retailing of the lease return…must be a good thing too.
Can the “steroid package” be interpreted as a form of discount?
With the available technology is it fair to compare a used unit to a stock on the stock market?
Vehicles like stocks can be transacted online on a national basis to expedite and facilitate the conversion to money at the wholesale level.
In Canada contrary to the US the online conversion to money at the retail level is not as efficient…we have a very efficient wholesale conversion process accompanied by an inefficient retail conversion process.
With the available technology the retail conversion should be as fast and efficient as the wholesale conversion process.
The inexorable strengthening of the Canadian dollar has upset a fine balance that existed for several years prior…its been disruptive…with predictable reactions from the manufacturers.
The New Age Lease Think is being challenged to reap higher and higher hanging fruits merely to uphold an eroding status quo.
What’s a Used Vehicle
In the automotive business at the retail level a used vehicle is a profit opportunity or a loss opportunity.
After all is said and done and all the technology used up to empower ourselves and to empower the customer we are still “horse traders” and will always be “horse traders”. These days it might just be easier to trade horses than vehicles.
The rules and guidelines on how to make money and uphold values of used vehicles have not changed in countless years…it’s the same process with the same guidelines.
As Peter Drucker said “the essence of any business is to create a customer”
What’s a Good Used Vehicle
A used vehicle is an instrument that is put in the market to create a customer the faster it creates a retail customer the better it is for all concerned.
A good used vehicle “moves / sells fast” and “makes money” is easy to “transact” at the retail and wholesale level. It quickly and efficiently creates a customer generates cash flow and a profit.
Empowered by technology its expected that used vehicles transact and convert at the retail level in shorter times frames.
Business Model
The ongoing mantras in the automotive business is that everything and anything is changing, the business model is changing, times are changing, expectations are changing.
We quickly become apostles of change, and recite various change mantras to serve our purposes.
There are vast quantities of presumed change, it becomes a huge ball of grey bouncing in a multitude of directions with justifications, and corroborations for any and every direction that the ball bounces.
The Canadian used vehicle customer follows the various bounces of the ball and the business model that make sense to his own interests and while offering the best security and peace of mind.
The Certified Pre Owned Corporation has enjoyed a good level of success in the recent past, especially that it was the new entrant with substantial advertising and focused representation from manufacturers.
CPOC has finally taken the lowly used vehicle and brought to the forefront of awareness and emulated the process that applies to new vehicles.
The used vehicle business model is changing, evolving, morphing, rejuvenating itself as it moves forward with fresh and innovative perspective, empowered by technology, and a creative mind set.
The wholesale conversion to money moves at a faster pace than the retail conversion to money. The Canadian dollar has gained in value and reached a point where the customer is becoming an activist regarding prices of new vehicles.
The CPOC is facing a new and disruptive entrant the Imported Pre Owned Corporation which is poised to upset the established order.
The business model is showing signs of strain and could use a fresh approach.
Impact of Technology
Technology has impacted in a positive and negative manner for many years…the advent of broadband Internet has enabled quantum leaps in a myriad of ways that at one point no one even remotely thought were possible.
Its cool to be in a technology empowered automotive environment, its also frustrating, and the weaknesses become glaring.
For the customer the technology empowers him as a hunter gatherer of information…when the customer can look at an entire photo gallery of a used vehicle from the comfort of his home or office. This is great.
The technology empowers a dealer to purchase a used vehicle at the wholesale level, and it empowers a customer to purchase the same vehicle at the retail level. It’s the same technology with different applications.
Most of this technology migrates north after having been deployed in the US for a period of time. In Canada we should have comparable results as the US.
Often times in Canada the technology is deployed with an opaque window covering compared to the US.
Lately all this technology is focusing on the wholesale conversion of vehicle to money…there is so much technology being deployed that a used vehicle in the near future will have an MRI…every new deployment of technology generates a fee for someone and a cost for someone else.
The chasm that is not crossed….the technology empowers and generates purchase decisions at the wholesale level…the technology empowers the hunting and gathering of information at the retail level.
We are not even close to crossing the chasm from hunting and gathering to actually purchasing at the retail level.
Erosion of Values
For all intents its a complex multi faceted issue with a myriad of opinions.
In reality its very simple, so simple that its confusing.
In an environment empowered by technology the value of an item is quickly set by the market to enable a timely transaction (conversion to money).
A few months ago the Canadian retail market signalled to the Canadian automotive industry that it was not prepared to pay artificially high prices for any vehicle be it new or used. The message was clear, focused, concise, and blunt.
When the Certified Pre Owned Corporation disseminated the message that if a vehicle did not originate from them it was of lesser merit and value…they were simultaneously protecting and denigrating their product. The end result, they ultimately eroded the value of their product.
The multitude of tactics by all the manufacturers to apply steroid packages to their Certified Pre Owned and simultaneously block imports merely reinforced the fact in the eyes of the customer that “something” is going on.
The increase in lease returns is creating a situation of supply being stronger than demand.
The ongoing promotions and incentives on new vehicles apply constant pressure to undermine the value of used vehicles.
In a market place empowered by technology, the technology becomes the equaliser in upholding or eroding values, its also the equaliser in communicating clear and focused messages.
Values
The horse trader of 100 years ago did not have the technology that we have today, they traded horses, and knew what horses where worth.
The same for the automobile dealer of 50 years ago, they traded cars, knew what cars were worth, knew what would sell, and not sell, what was a retail unit, and what was a wholesale unit.
Today dealers are empowered by technology, and many decisions that were made by applying a human knowledge base are deferred to technology.
The wholesale side of the business is desperately attempting to raise wholesale prices (values) the retail side is desperately attempting to lower retail prices (values).
In this ongoing struggle between wholesale and retail, the retail side will win every time. Values are inexorably compressed downward by the retail side of the business.
Technology can facilitate the manipulation of values at the wholesale level, this manipulation acts as an additional force to erode values.
The stock market has an established daily retail price for a multitude of shares, with brokers charging a fee to effect a transaction. Shares do not require reconditioning, warranties, inventory facilities. It’s the retail market that establishes the value of shares.
In the automotive business it’s the wholesale market that establishes the value of vehicles, with the retail market lagging several steps behind in establishing an actual transaction generated value.
Lease returns aggravate the emphasis of maximising values at the wholesale level, irrespective of the values at the retail level.
Distribution Channels
At the wholesale level the major North American auction houses are the primary distribution channels / clearing houses for vehicles.
The auction houses offer a variety of services to quickly and efficiently convert vehicles to money. Empowered with the latest technology they facilitate transactions, and provide analytical services that are useful mostly to the sellers.
At the retail level there are franchised new vehicle dealers and independent used vehicle dealers which are the primary retail channels. Compared to the wholesale channels the retail channels in Canada move at a glacial pace.
The wholesale channel can be compared to a hub and the various retail channels (dealers) are the spokes of the distribution network. Once a vehicle reaches the end of a spoke and starts interfacing with an empowered retail customer the decision process is much slower than at the wholesale level.
Lately in Canada the retail channel generates transactions at a much slower pace them the wholesale channel. Its safe to say that the retail channel is a restrictor in the flow of transactions.
Canadian Dollar
Much has been written and discussed on the value of the Canadian dollar, the reaction from the customers, the reaction of manufacturers, the importation of vehicles from the US.
The Canadian dollar had been strengthening for a few years, it was wishful thinking to conclude that the status quo would remain unchallenged by an empowered customer / consumer.
For several months the media played an active role in empowering the consumer to literally demand lower prices on new vehicles.
Did the strengthening of the Canadian dollar erode the value of used vehicles. Its convenient to cast the blame on the Canadian dollar to justify residual losses. Did the dollar devalue used vehicles?
Perhaps the dollar reaching parity was the signal that “something” was not correct with the pricing of vehicles in Canada. Parity initiated a domino effect that continues to reverberate across the Canadian economy, not just the automotive industry.
How did Values Erode?
In Canada the retail channel is not efficient to absorb the number of vehicles that the wholesale channel can generate. Once the distribution spokes are full of vehicles from the wholesale hub the entire system slows down.
The advent of the Certified Pre Owned Company created a tiered price scale for used vehicles which erodes values. Especially when CPOC applies “steroids” to gain a market advantage.
Technology acts as an equaliser, the wholesale channel uses technology to enhance prices, the retail channel uses technology to depress prices. At this point there is an inherent imbalance between the 2 channels, the immediate result of this imbalance is to erode values and prices.
The playing field and market have been disrupted on several occasions to gain an advantage. If advantages were gained they were tactical and short lived, the disruption is enduring increasingly eroding values.
Do you get the impression that the industry became its own enemy? Quite possible.
Lease penetration is 50% in Canada overlooking or conveniently forgetting the second step in converting a lease return to money is foolish. Why would anyone do such a thing?…numerous self serving reasons.
Once outside events start influencing and affecting the used vehicle market it gets very interesting…everybody has an answer and a reason and nobody has an answer.
In the meantime values continue to erode.
The Canadian Difference
In a wired world at times it becomes increasingly difficult to make clear and concise distinctions in our minds between one location and another and one country and another. Many comments and opinions that we read emanate from US pundits with a US perspective.
Canada is different…the Canadian consumer does not transact used vehicles online compared to the US consumer. At any time there are usually 25,000 vehicles listed on eBay in the US and 500 on eBay in Canada, at ratio of 10 to 1 there should be 2,500 vehicles in Canada.
Its safe to say that leasing penetration in Canada is double the US, we are at 50% and the US is at 25%.
From a different perspective…half of the new vehicles delivered to a Canadian customers are only partially converted to money when they are delivered to the customer. They also remain on the books of the captive finance company as a residual value risk that is converted to money in a 36 or 48 month time frame.
In Canada half of the new vehicles take 36 to 48 months to be fully converted to money and the ownership transferred to a new owner.
Since the automotive industry literally functions month to month, and surpassing the previous month and the previous year is very important generating results now is a robust priority. This makes it easy to overlook the second part of the sale which will occur in 36 or 48 months.
It takes a longer time frame in Canada to fully convert vehicles to money, in an industry that functions with increasingly shorter time frames. Accompanied by a Canadian consumer that is conservative and does not readily transact used vehicles online.
More Difference
One remarkable outcome of strong lease penetration in Canada is the strong predictability of monthly sales.
Did I fall off a cliff?....No!
Overall lease penetration is 50% for the more expensive makes its at least 50 and probably higher. At times there are people saying “ I read that the economy is slowing down, that prices are rising, real estate is stable, and new vehicle sales are going through the roof in Canada” . It’s a fair question to ask.
Lets look at this from a different perspective…vehicle sales are going through the roof since leases come to term, people walk away from their lease return and its literally a better deal now in 2008 to lease another new vehicle.
In Canada there is an extensive fleet of leased vehicles that comes due every month, and gets renewed by starting a new lease on a new vehicle and walking away from the previous lease.
Its truly a Canadian difference and phenomenon.
This Canadian phenomenon creates an ample supply of lease returns that are distributed into the retail channel were they face robust and aggressive competition from the new vehicles.
Is it a healthy and confidence inspiring situation? Yes, we could have a lengthy and animated discussion with a myriad of similar and diverging perspectives.
This is the way it is in Canada we have never sold so many vehicles, although we had to lower our prices we are making up with volume, and if profitability is challenging with new vehicles, we are making up with Certified Pre Owned.
Used vehicle values are being challenged and headed for “bad times” we will cross that bump in the road when we get to it.
In the meantime we keep on converting lease returns to new vehicles, the money will follow.
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