The changing landscape of the dealership

UK car dealerships – a guide for investors

Investors and lenders with interests in UK car dealerships need to consider the unique set of challenges the sector is facing before making decisions about their portfolio.
 

A sector under pressure

UK car sales are experiencing a downturn. A seven per cent annual decline in new vehicle sales in 2018 has been followed by a further three per cent contraction in the first six months of 2019. Sales of used cars have also declined, falling two per cent in 2018 (and a further 1% in Q1 2019).

Although some dealerships have managed to maintain a high level of performance during this decline in sales, a significant number are now operating at a loss. For example, there are 250 dealerships with turnover above £30m in the UK, with the top ten (by revenue) ranging from turnover of £991m to £9.3bn. Of the total number, 15 per cent incurred a loss in the latest available financial year. Of the 150 dealerships with turnover between £10m and £30m, 19 per cent were loss-making.

Consolidation intensifies competition

Despite the challenges, the last couple of years have seen high exit multiples (a measure of the value of an organisation) on car dealerships. These valuations have led to many private equity backed and privately owned dealerships choosing to exit. As a result, the sector has seen substantial consolidation over the past 24 months.

Consolidation has intensified competition, making it harder for smaller players to compete based on price or geographic coverage.

As competition increases and sales contract, the number of loss-making dealers is expected to rise. As a result, investors need to consider how best to manage their portfolios. Understanding the challenges that dealerships face in the short to medium term is key to this.

Key issues for dealerships

There are a number of factors that have contributed to the current challenges dealerships face. The majority can be summarised in four key areas:

• Consumer behaviour
• Trading environment
• Regulatory environment
• Structural change

Consumer behaviour

Consumer behaviour is changing. The modern car buyer demands more from their dealer, forcing them to invest in, among other things, digital technology and prime real estate in high footfall areas.

But while consumers are becoming more demanding, they are also becoming more cautious. The results of the 2019 Q2 Deloitte Consumer Tracker indicate that consumer confidence remains close to a one-and-a-half year low, with consumers remaining cautious about the UK environment, including possible implications of Brexit and how this might directly impact them. This has had a direct effect on car dealers, with consumers delaying or simply not making vehicle purchases.

And it is not just individual consumers who are exercising caution when it comes to buying a car. Deloitte’s most recent CFO survey cited growing economic headwinds, increased cost pressures and less accommodating credit conditions as drivers of, among other things, depressed expectations around capital expenditure and high levels of financial and economic uncertainty. Under these conditions, it is understandable that organisations are unwilling to make large investments, meaning that the fleet car market is also suffering as a result.

Trading environment

In addition to changing consumer behaviour, dealers are also facing an increasingly difficult trading environment which is directly affecting their bottom line. For example, trading environment conditions are contributing to high fixed costs and small margins on new vehicles increasing the risk of losses when volumes decrease.

Another major issue facing dealers is the relationship between the new and used vehicle markets. Consumers often part-fund a new purchase by trading in their previous vehicle. This means that if the number of new vehicle transactions decline, so too does the supply of used cars for resale. And it is not just the quantity of stock that matters, quality of stock is also a major factor in a dealer’s ability to operate profitably. For example, an increasing number of consumers are no longer interested in buying cars that have large, high emission diesel engines. Used vehicles are traditionally higher margin, but if the quality of used stock is not well managed then these higher margins are at risk.

Dealers are also exposed if they rely on manufacturer bonus schemes. Such schemes have traditionally been critical in maintaining profitability as margins on new vehicle sales continue to erode. However, supply issues over the last 12 to 18 months due to new worldwide harmonised light vehicle test procedure (WLTP) emissions legislation have made volume targets difficult to achieve.

Regulatory environment

The business practices of dealerships have come under scrutiny in the past few years, with a sharper focus on protecting consumer interests. While increased consumer finance regulation will require the sector to adopt new ways of working, it also presents a major opportunity to increase consumer trust and satisfaction.

The Financial Conduct Authority (FCA), who is primarily responsible for regulating the finance industry, recently finalised a report into motor finance. The relevant findings for dealerships were:

• possible inappropriate commission structures (raising issues over the sustainability of existing business models)
• inadequate disclosure on the available financing products and commissions receivable at the point of sale.

The FCA has warned of possible supervisory action or enforcement where weaknesses have been identified. For commission structures, if the suggested regulatory standards leads to amended charging structures (or a considerably narrower interest-rate bandwidth) dealers will need to consider the impact on their bottom line, and identify where income shortfalls can be rectified. For point of sale disclosure, dealers should undertake a review of their systems, processes and controls, to ensure they comply with the regulatory standards.

Dealers also need to consider the FCA’s findings from its review into general insurance (GI) distribution chains, which noted potential consumer harm arising from the commissions received on GAP (guaranteed asset protection) and other ancillary motor insurances. This was accompanied by a ‘Dear CEO’ letter addressed to GI distributors, which indicated that supervisory work in this field will continue.

In addition to the FCA findings, dealers also find themselves under pressure from other regulatory bodies. For example, an investigation by the Advertising Standards Agency into the mis-selling of ex-hire, ex-lease or ex-fleet cars by dealers who claimed they had only one previous owner could result in compensation payouts of between 25 per cent to 100 per cent of the price paid.

Structural change

Digital disruption is at the heart of the sector’s structural change. For example, online portals enable the consumer to compare prices directly and save time by visiting multiple dealers. The ability of consumers to do their financing online on third-party websites has also disrupted the traditional market.

Our report on the future of car sales examines how changing consumer behaviour, digital disruption and an influx of new entrants to the sector are forcing OEMs to seek competitive new business models. These include reinventing the offline experience, offering a dedicated e-commerce platform or creating an omnichannel service for consumers. The new business models that are emerging in the sector have serious implications for dealerships as the three-way relationship between manufacturer, dealer and consumer is set to change.

Structural changes are also being driven by political factors. The society of motor manufacturers and traders has warned that import tariffs (if applied post-Brexit) could drive up the list price of new cars by around £1,500 and add ten per cent to the cost of car servicing and maintenance due to tariffs on imported replacement parts if retailers are unable to absorb the additional costs.

Other key changes that need to be considered include the requirement of the sector to adapt to electric vehicle (EV) sales, associated servicing timelines on the new vehicles and the, as yet, relatively unknown market for used EVs.

New strategies required

To deal with the challenges facing the sector, there are several strategies that dealers and their investors should consider implementing:

• The high cost of property for both car and high street retailers has seen OEMs considering partnerships with retailers. OEMs and dealers should be able to interact with their consumers without committing to large out of town sites or holding large amounts of stock.
• There are 20 dealership groups in the UK with over 50 sites, and 7 with over 100. Of these groups, eight have rent costs of over £10 million per year, suggesting company voluntary arrangements (CVA) could be a mechanism for larger dealership groups facing financial distress, as many of the large retail CVAs have led to reduced rent costs.
• While conserving cash through careful working capital management helps in the short term (the Q1 Deloitte CFO survey highlighted a greater emphasis on cash accumulation than at any time since 2010, with 52 per cent of CFOs stating that increasing cash flow will be a strong priority over the next 12 months), more wide-spread restructuring of operations seems inevitable for many dealerships to remain competitive.
• Some dealerships may benefit from performance improvement and turnaround support – whether that be traditional cash management advice, accelerated merger and acquisition processes for all or part of the site portfolio, or the creation of full turnaround plans and implementation support.
• Consolidation (particularly with larger players acquiring sites or entire businesses) is a potential exit strategy followed by many stressed dealerships, and has resulted in increased revenues for the big players, although profits have remained flat.
• Asset realisation strategies may need to be considered in some cases by dealers seeking to raise funds from sites they own. Such a strategy could include assessing the potential to sell the site for alternative use (dependent on location) or to a different dealer with a strategic requirement to enter the market in a specific location.
• Diversification in terms of brands (both premium and volume) and services offered (body shop/service function are both higher margin than vehicle trading) are key attributes often found in stronger performing dealerships.

Next steps

Despite the challenges faced by the sector, it is unlikely that we will see a wholesale change in the approach to new and used car sales in the short to medium term. The traditional dealer model remains the first choice for the majority of consumers. Although online is now a tangible option when buying a car, many shoppers prefer the immediate, tactile experience of physically interacting with a vehicle before buying it, while some prefer in-person interactions with dealers, trusting their knowledge and feeling more comfortable negotiating a deal face to face. However, we expect to see adjustments to the traditional dealer model to make it more relevant to the modern consumer.

Lenders and investors should ensure any car dealerships in their portfolio are performing as planned and, if not, seek to confirm that plans are in place to meet the current and future challenges that could impact the sector.

Many dealers are already making investments to prepare for changing consumer behaviour. Dealers should also start to prepare (if they are not already doing so) for the trading environment, regulatory and structural changes that could impact them in future. For example, dealers need to ensure they are diversified and willing to adopt new technology to embrace disruptors so that they can turn potential challenges into opportunities for their company, their consumers and stakeholders. Furthermore dealers need to consider how their compliance framework codifies the FCA’s regulatory requirements into business requirements and processes to mitigate the risk of non-compliance.