March Light Vehicle Sales: Discrepancy Between Media and Reality

The month of March is over. Vehicle sales are officially in. And while the headlines sound pretty negative, for those of us that listened to the conference calls, I definitely walked away with a different perspective than the picture that is being painted by the media.

For example:

Reuters: "U.S. Auto Sales Fall." "Total industry sales were 1.54 million units, down 2.9 percent from a year earlier after adjusting for an extra selling day in 2007."

The Wall Street Journal: "Detroit begins Spring in a Fog." "Detroit's Big Three auto makers face worsening economic headwinds as they head into the crucial spring selling season, threatening their efforts to stem sales declines."

MarketWatch: "Ford March Sales Drop 9%." "Ford Motor Co. on Tuesday posted a 9% drop in March U.S. sales, led by a double-digit decline for its flagship F-Series pickup, as domestic automakers continue to suffer from a general migration away from bigger, fuel-thirsty trucks."

And perhaps the most interesting was an article by Sarah Webster of the Detroit Free Press published yesterday morning that a dealer sent me.

Detroit Free Press: "Traffic down on auto lots." "It's hard to sell new cars and trucks to customers who aren't shopping. . . Floor traffic in showrooms nationwide declined 3.5% in January compared with the same month a year ago. That was followed by drops of 15.8% in February and 16.0% in March, according to a floor-traffic index maintained by CNW Marketing Research in Bandon, Ore."

Now let me share with you what I actually heard on the automaker's conference calls yesterday:

Paul Ballew, GM's head of industry analysis: "We continue to expect the industry to sell around 17 million (light and heavy) vehicles in 2007. . . Having said that we need to get our arms around the headwinds from housing and energy. . . The recent developments add some risk. . . But we are comforted by the fact that the first quarter hit the numbers we were expecting for the industry."

George Pipas, Ford's head of sales analysis: "At least through Feb, lower levels of fleet deliveries more than accounted for the decline in total industry sales. So the retail business in the first three months is holding up pretty well versus a year ago."

Steven Landry, Chrysler's Vice President of Sales and Field Operations: "With more launches to come in 2007, we are very confident especially going into second quarter, where we feel very good versus our April and May sales of last year. And we also believe that the plan we have going forward both from a dealer standpoint and incentive planning standpoint is one that will take us into one of our better quarters to come."

What I said last year
But maybe the most interesting thing is to look at what I wrote last year (April 4, 2006) about first quarter 2006 vehicle sales:

We continue to worry that the sales volumes in the month of March (the most important month of the quarter) were sufficient to meet dealer (and potentially investor) expectations. Importantly, while inventories continue to move lower (year-over-year), the rate of improvement is ebbing. To wit, in February, industry-wide dealer inventories were down ~9%, consistent with 4Q improvements. This compares with ~18% improvement in 3Q.

In March we believe the early sales data suggests inventories improved 8% - 9% from prior year levels. We continue to think these compare against abnormally high levels (~4 million in March of 2005), and this rate of improvement may be difficult to sustain as we head into the summer months. We note, inventory improvements are necessary given over 200 basis points in higher interest rates dealers must absorb.

And sure enough by the third quarter of 2006, dealer inventories had completely reversed course and were up ~9% from year ago levels. I am not trying to brag, you and I both know there are about 5k other emails I can point to where I was wrong. And my intent is not really focused on trying to "make some call" on what the future holds. My focus is on helping you understand what is really going on in the industry, so you can make prudent investment decisions (based on whether or not there is really an underlying need and who is most efficiently delivering on that need). But that philosophical approach to investing is something I plan to address at a later date.

What I think about this year
Importantly, the point is that things were probably worse than what the headlines suggested last year in the first quarter (as fleet sales "padded" the results). And while things have not necessarily improved, I find it difficult to understand how traffic at dealerships are down so much and yet RETAIL sales were basically flat (if not up) from last year's first quarter. And even with the declines in fleet sales in this year's first quarter (as the automakers try to ease off those less profitable daily rental car sales), TOTAL (fleet and retail) U.S. light vehicle sales were only down a little more than 1% from last year's first quarter.

At least this year, it does not seem like dealers are expecting things to be great. And this means their budgeting (which I think inventories provide the best gauge of those budgets) is probably running pretty cautious. In March, GM's dealer inventories were down 8% (year over year) to 1.08 million, Ford's dealer inventories were down 27% (year over year) to 573,000, and Chrysler's inventories fell 18% (year over year) to just below 500,000 vehicles. All in, I guesstimate industry-wide dealer inventories fell about 6% (year over year) in March 2007 versus the 3.9 million units the industry had last year in March. And on an unweighted average basis (throughout the quarter), I figure dealers generally held about 4% fewer vehicles (1Q07 versus 1Q06).

Is there weakness in Florida and California? George Pipas, Ford's head of sales analysis directly addressed this when Sarah Webster of the Detroit Free Press asked on yesterday's conference call:

You asked me about this last month, so I did some research. Not extensively, but if you look at retail, not just F-series, overall, some of the largest declines (year over year) are in the markets you mentioned.

But even in those markets, we have seen evidence where auto retailers have persevered. For example, on the Sonic Automotive (SAH) fourth quarter 2006 conference call they said that the profits in their California stores were up (year over year) despite the difficult market. And like I discussed after the Asbury (ABG) analyst day a couple weeks ago in New York, even though they saw declines in their new vehicle and finance and insurance gross profits in their Florida stores (which as I recall the Florida market accounts for something like a quarter to a third of their total company profits), total gross profits for Asbury's Florida stores were actually up (year over year) in the fourth quarter. Why? Because they focused on their used vehicle sales, and higher used vehicle sales and gross profits offset the weakness going on at their Florida stores. My point is that good retailers adapt to the changed external environment.

Everyone stumbles, and I am not saying that good retailers can not have a bad quarter. Heck, Lithia's (LAD) bad streak has gone on far longer than I have ever observed since I began writing investment research on them back in 2001 (and going back well before that during the due diligence phase). And so I guess you can understand my disappointment when Chrysler announced yesterday they planned to continue their "volume purchase allowance" (VPA) dealer incentive program. With Lithia's CEO on the Chrysler dealer council I had hoped he (along with other Chrysler dealer leaders) would have been able to persuade the Chrysler management to end this ridiculous program.

Sure Chrysler management emphasized on the call that they arrived at the conclusion to keep the VPA program in its current form for the remainder of the 2007 after seeking the input of the Chrysler dealer council and town hall meetings throughout the country with Chrysler dealers. And it sounds like Chrysler management has been hard at work to improve dealer relations and more importantly, their dealers' profitability, as illustrated by the 18% drop in dealer inventory levels.

But any program that allows the manufacturer to decide what incentives they will give the dealer for the previous months vehicle sales based on what they will order in future months (as I understand the program does), just invites inefficiency and ultimately encourages dealers to stock their lots with unnecessary vehicles.

This (encouraging dealers to stock their lots with vehicles they don't need) may sound nice at first to a manufacturer, as you have heard me discuss in the past, when they are faced with high fixed costs at the plants. But over the long run what it really ends up doing is making the manufacturers' products less competitive as competing brands (like a Toyota that ended the slow selling month of February with only 48 days supply of vehicles) dealerships can spend less money on floor plan interest expense, and therefore divert those expenditures to things like advertising, or better sales person training (etc).

If there is one external factor that I think we (as industry observers) have under estimated, is how much the gulf state (and even Southern Florida) region(s) benefited after the hurricanes in the third quarter of 2005. I think this is what drove such strong demand for the F-series in the fourth quarter of 2005 and first quarter of 2006 as a lot of re-build reconstruction work caused small business owners to buy these vehicles, and why you see the weakness in this product area now (in 4Q06 and 1Q07).

So I give Earl Hesterberg (Group 1's CEO) a lot of credit. Because when he came on the company's fourth quarter conference call and was asked about hurricane comparisons he said: "well you didn't hear us complaining when we benefited from the post hurricane re-build, so we probably shouldn't complain about the tough comparison's now." Although he kind of spoiled the moment when he discussed the California housing slow down impacting their California dealerships.
The coming six months may be the most telling (and interesting) to observe yet!

The bottom line is that the industry environment is difficult. But at least now (unlike the Spring of last year), it seems like dealers recognize the difficult environment and are budgeting and planning accordingly. Based on my experience, when this happens, the automakers (faced with the prospects of lower production schedules) step in (likely this summer) with some new novel incentive program. In 2001 and 2003 it was various 0% financing initiatives, and in 2005 it was the employee discounts. Every other summer dealers and (shareholders of the publicly traded dealer stocks) have found a pleasant surprise (in the financial results) from these programs. 2007 would follow this pattern perfectly and therefore dealers might be pleasantly surprised as we move into the second and third quarter of this year.

However, experience can be a dangerous thing (as you can miss real shifts that happen in the industry environment). This is the first time I have ever seen the automakers make real strides in reducing their fleet mix. It almost suggests that the employee buyouts at Ford and GM (that reduced their hourly workforce by roughly a third since last year) have really lowered "manned capacity" and therefore it is no longer "cheaper" to pay consumers and dealers to keep the plants cranking.

Maybe the domestic automakers are finally at a point where it becomes cheaper to run lower production schedules? If this is the case (where the manufacturers' find it less important to pay consumers and dealers to keep their plants cranking), I think things will get even more difficult for dealers when the summer approaches. And if the AutoNews article is even remotely close about half of all dealers in January losing money (granted it is a seasonally slow month), we may very well see some pretty dramatic shifts in acquisition multiples as the incentive to exit the market increases. Unlike several years ago when dealers were saying "this will pass," I suspect a downturn this summer (after more than half a decade of eroding dealer profitability) might finally compel a bunch to sell or maybe even simply close their doors (if they can get out of the lease).

So if we see pretty good results out of the public (and private) dealers this summer, it will be the "cycle" that I have come to know, observe and constantly discuss ("tug of war") for the last six or seven years. But if things don't improve out of the public and private dealers this summer. Remember that "massive consolidation wave" I have been saying is likely to occur in U.S. auto retail sometime in the next five years? Watch out, because this summer may push the industry into this "rationalization period" in 2008/2009. So fasten your seat belts. This may prove to be the most interesting (and telling) six months (to observe) in auto retail yet!