Andrew Kuhn April 8, 2020

What Kind of Competition Will Car Dealers Face for the Sale of Used Cars and for Their Parts and Service Business?

Someone sent Geoff this email (to ask your own question: just send me an email):
I think that car dealers face a lot of competition, especially for used cars and service, that I could never thoroughly understand the competitive advantages. But car dealers tend to have very stable margin. So I do think that they have certain competitive advantage thanks to location, long-time presence, as well as customer relationship built up through its new car business. So, I’d like to ask you about your thoughts on the competition for car dealers in:
1. Used cars where car dealers have to compete not only with franchised dealer of another brand in the same area but also with independent used car dealers.
2. Parts and services where car dealers have to compete with independent auto service shops and chains.
Answer: I Think Big Car Dealer Groups Have Certain Advantages in Capturing Additional Profits from a Customer Relationship Based on a New Car Sale – But, the Internet May Change Things Over Time
It’s a good question. I think it’s possible that an independent seller of just used cars might be a better business – especially if it combined locations with a really, really strong internet presence.
Big car dealer groups do have to compete with service shops. And perhaps they have lost share. But, the number of dealer locations relative to the amount of population (and certainly to drivers) has been declining throughout much of the history of the industry. So, I think the business has tended to get better not worse.
What’s the big difference?
I think two things benefit dealers.
Once, they potentially have a better source of leads for their new, used, and service businesses – in the form of a new car territory they control for a brand. So, often, when someone is in the market for a new Toyota they trade in their old Toyota. The dealer can take the trade in (getting a better supply of used cars than others might) and can get the possibility that the owner of the new car will buy financing products etc. through them and – most importantly – stay with them for servicing. So, they are in a better position than some to turn a new car sale into out sources of revenue – a possible service relationship, a good price on a trade-in used car, etc. This is why I think it’d be hard to compete in new cars even if there wasn’t the dealer system that there is. New cars are largely just a good way to have a customer relationship that can make you more money form things over time.
Second – and I think for most dealers, this is the bigger issue – I think dealer groups that include new car sales, used car sales, and servicing in one operation have a lower cost of capital than competitors would. It has been very easy for new competitors in the industry to succeed in stuff that doesn’t require capital. So, lead generation through advertising sites that are like the quote comparison sites for insurers has worked well. They just are a website that makes money from dealers. Things like AutoTrader (in the U.K.) have been very, very successful. And there are some ideas around doing everything BUT actually owning the car you’re selling that can be successful. So, for instance, there’s a U.S. company where the business model is just to have a location, then to list the car for the seller, then to bring the buyer and seller together at the company’s location, inspect the car, etc. and then the company can sell the financing etc. package to the seller. But, the company never owned the car – just a regular person who wants to get rid of their old car owned that used car. Again, this skirts the issue of cost of capital. I think that’s a feasible business model.
I think owning the land and car inventory necessary to have big dealerships is hard for companies. Inventory is a really big use of capital in the industry. And I think you need it. There just has proven to be very little demand for buying more expensive cars (new or used) without any brick and mortar component. This has not changed much. Now, some companies have tested things where they like deliver you a car and you get a free-trial period of driving it around for a couple weeks and then if you don’t return it – you buy it, or something. That kind of program might help move some people off brick and mortar and into online only. However, there have proven to be at least two problems with competing through online only. I’m talking about online only, because that’s the best way to reduce capital costs. I don’t think that independent dealers / service organization can have as low a cost of capital as larger groups affiliated with manufacturers – so, I think the best way to compete is using the internet.
Anyway, the issue with online only has been that: 1) People want to test drive the car and 2) People believe they will get a better deal by negotiating in person. There’s been pretty good surveys of this, and people do believe it. The same is true on things like houses. People are in the habit of not just paying $300,000 for a $300,000 listed home but instead offering less than that. Or, if there is bidding competition offering more than that. So, people haggle on houses. Likewise, they haggle on cars. Surveys show car buyers believe they get a better deal from visiting a dealership in person and negotiating. That’s a little hard to believe, because they are haggling at the dealer location with professional salespeople while revealing more and more about their finances, personality, preferences, intentions, etc. But, people do believe it. People ask others for advice on what car to buy, how to negotiate, etc. It’s not been a very common transition for people to move 100% to online – even among millennials. What has happened is a lot of research gathering online. But, if you look at the patterns for say how the online travel industry works versus the online car industry – people do a lot of the same research for about the same amount of time when planning a trip and when planning the purchase of a car. But, then they just book everything online now for travel. However, they still finish the car purchase in person.
Independent service organizations have always been competitors of car dealers. And they seem like a viable threat. In many cases, I don’t know why the dealer is really a better choice for servicing. Especially for basic sorts of servicing – I’m not sure it is. There are some reasons people use them. The dealers work on customer retention. They often offer the first few service checks, oil replacement, etc. free to get the customer in the habit of going to the dealer. Obviously, the dealer is reasonably close to the buyer if the buyer chose that dealer in the first place. Recalls need to be taken to the dealer. And there are plenty of recalls in the auto industry. And then some people are convinced that the dealer will do a better job than an independent service chain (garage). Finally, we have to remember the psychological benefit of doing a deal in person (sometimes over a period of a couple hours) at a dealer location to close a deal. Nothing builds trust like a face-to-face interaction sustained over a period of time. So, dealers have an unfair advantage over anyone else in that they’ve already had the customer in their store and agreeing to a really big purchase. The initial purchase is a lot bigger than subsequent servicing. And, remember, customers have no clue what servicing should cost, whether the diagnosis made by the garage is accurate or fraudulent, etc. – so people sometimes treat mechanics like doctors. They have one they trust and go to for a long time. They ask people they know to suggest a good mechanic. And they often get a second opinion, look online, etc. if they are faced with a proposed action by the mechanic that’d be really expensive. So, this is more of a trust industry than most consumer businesses because it’s the second biggest purchase most consumers will ever make next to buying a house.
Now, there are parts of this industry that I think don’t fall into any of this. I think really cheap used cars – especially ones bought for cash – just aren’t in the same category as what car dealers sell. If the customer’s goal is just basic personal transportation (and a lot of drivers say this is their goal, but they pay far more than what’s needed for that – so they have other priorities too) I don’t think dealers compete well in this. Individuals who want to sell used cars for cash can easily do it on the internet (in the past, it was easy to sell through classified ads in newspapers). There is a whole industry of selling cheap cars for cash which includes really small used car lots, people who just want to unload a used car they have, etc. I think this is very different from the kinds of used cars that dealers often sell. For example, it’s totally different than like selling rental cars after they are put back into the market. Basic personal transportation can be a model that was already cheaper to begin with and is like 10 years old now. It would not be hard in the U.S. to find 10+year-old Toyotas of various kinds that would provide basic transportation for another 5 years or so. That’s not what car dealer groups are looking to sell. That’s what people either: 1) Buy for 100% cash via the internet or 2) Go to places like Car-Mart, DriveTime, etc. to do low down payment, high interest, once every payday loans if they have neither meaningful cash nor credit. Again, I don’t think that’s the population dealer groups focus on.
Finally, I’ve thought about the economics of car dealers versus things like competition, the total size of the driver pool, etc. – and I’ve come to the conclusion that projections for like the growth of car sales aren’t relevant here. The economics of an individual dealership depend on things like their cost of capital, how many dealers are nearby that can compete with them, etc. Risks like a decline in driving because of Uber or something, a move to more internet sales, etc. are pretty complicated in seeing directly how much that hurts large dealer groups. This is for two reasons. One, if the shrinking of the industry shrinks the pool of dealer locations by at least as much as it shrinks the demand for cars – it’s not damaging to the remaining dealers. If the industry shrinks 20% over a decade or two and the number of dealer locations drops 30% – that shouldn’t be assumed to harm the remaining dealers. I generally believe there are many very weak smaller dealer groups – and especially one dealer locations – that won’t survive the times we’re in now. So, the dealer extinction rate will almost certainly be higher than the decline in car sales over time. I’m talking longer-term. Obviously, car sales will plummet this year and probably stay low for some years following. Then, as for the internet, it just seems easy to me for large car dealer groups to use the internet to their advantage. It seems easier than the reverse. If you have a good online system for selling cars – that’s fine, but you don’t have the locations and the inventory. So, an ad supported or commission (like brokering “leads”) online business seem to be the way for non brick and participants in the car industry to monetize their online audience. Ideas like owning a big inventory you keep centralized and then delivering it based on sales made on your website and stuff – that doesn’t sound promising to me. And, of course, if dealers sell more online – they’ll need fewer locations. So, they can thin the number of locations and widen their “circle of convenience” of what customers they can serve. If all you’re doing is delivering a car to someone, you don’t need a dealership as close. If fewer people go to each dealership, you can sometimes combine dealerships. Dealers of multiple brands may often be able to close 1-2 locations around a bigger location and move everything into one consolidated location to serve that town selling 3 different manufacturer brands instead of just one. This will free up the most expensive capital in the business. Dealer groups have good cost of capital on cars – but, not so much on locations. They either lease or they own pretty big properties. I think a dealership is rarely the “highest and best use” for property. They need the property, because they have to own some land (or lease some land) somewhere in that town in a visible enough and accessible enough place. But, in most cases, I think the land could be sold and be more valuable to a business unrelated to cars. I think it’s generally true that if you knocked down car dealers and put up chain restaurants, big box stores, etc. where they were located – the ROI of the new tenants will be higher than the ROI of the old tenant. Car dealers just aren’t that profitable versus the value of the land they have to sit on. So, it wouldn’t be a bad thing for dealer groups if they could do the same amount of volume out of 80 locations that they are now doing out of 100 locations. Just as online banking reduces but doesn’t eliminate the need for bank branches – I think online will reduce the need for dealer locations in the long-run. But, that should increase efficiency of the remaining locations. Like I said, the cost of carrying inventory (either new or used) on premises is quite reasonable for a large dealer group. So, stocking fewer locations with more cars isn’t a terrible thing if these become more centralized, higher volume locations.
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