With relatively flat sales trends, continued margin compression, complex manufacturer incentive programs, and rising interest rates, today’s automobile dealerships face an array of new financial pressures.
In view of these concerns, prudent lenders should consider enhancing their use of financial due diligence to monitor how well their dealership clients are managing these issues. In addition to providing better visibility into their clients’ financial stability, lenders’ use of enhanced due diligence also can benefit dealers by offering insights into risks and adverse practices they might not have recognized on their own.
Dealers’ evolving challenges – why lenders should take notice
Many of the financial pressures dealers currently face stem from external economic developments beyond the control of individual dealers or the industry as a whole. For example, although recent Federal Reserve commentary suggests interest rates might be stabilizing for a while, the increases of the past few years have had a significant effect on many dealers, particularly when manufacturers’ interest assistance programs have not kept pace.
High inventory levels and rising wages within dealerships have added to the pressures, but one of the leading contributors to many dealerships’ financial situation has been manufacturers’ continued use of volume incentives, particularly stair-step programs that require dealers to achieve ever-increasing volume levels in order to qualify for the quarterly bonuses that many have come to depend on to maintain adequate cash flow.
Coming at a time of relatively flat or slightly declining volumes across the industry, these incentives have tended to put an even tighter squeeze on margins. In addition, the generally improved quality of new cars in recent years contributes to lower sales volumes while also keeping a lid on service department revenues.
The effects of these incentives can be seen in the trend lines for certain important financial performance metrics, as tracked by Crowe among dealer peer groups. For example, overall dealership profitability, measured as net income as a percent of total revenue, has declined noticeably since 2015, particularly among domestic dealers. Concurrent with this trend, the average gross margin per new vehicle also has declined, while an ever-increasing share of dealers’ net income has come from the category of other income, which includes income from manufacturer incentive programs.
The value of due diligence
In spite of the changing financial pressures their clients face, it appears many lenders are not performing financial due diligence on a regular or consistent basis. For example, in a recent Crowe webinar, executives from a variety of lending organizations were asked when their organizations performed in-depth financial due diligence on their automotive dealer clients. As shown in Exhibit 1, only one-third (34%) of the participants said they perform due diligence regularly as part of the annual renewal process.
Exhibit 1: Lender due diligence practices