Last month the Bank of England’s Prudential Regulation Authority told banks and carmaker finance arms to stress-test their businesses and ask what would happen if the value of used cars on PCPs fell by 30%.
It wants to know that they are lending conservatively amid fears that some of the Guaranteed Minimum Future Values that underpin PCPs are too optimistic.
The prospect of a 30% fall in used car prices seems highly remote. The last time we got anyway near that was in the second half of 2008 in the financial crisis when prices fell by between 15% and 25% depending on the type of vehicle. This hit the big dealer groups who found themselves with too much stock on their hands.
The fallout was considerable. The UK’s biggest dealer group Pendragon set aside £24.9m for stock that had fallen in value as a one off item. It also took a £6.3m hit on its contract hire business. Premium cars, as often happens in downturns, were worst hit. It cut its used stock by nearly £100m in 2008 compared to the prior year, with £73m of the reduction achieved from June 2008 to December 2008. It also reduced vehicles for its own use by £23m over the prior year. Margins came under pressure. The Stratstone arm for example saw gross margins fall by 6.3% year-on-year.
Vertu Motors commented at the time on the big decline in used car values between May 2008 and December 2008, which put pressure on margins. It noted that lower part exchange values increased the cost to change for consumers and this dampened sales. There was also a tightening in the availability of consumer finance to used car customers, particularly those with weaker credit scores.
Mike Jones, chairman of dealer profitability specialist ASE, argues that while the Bank of England is looking at PCPs, the real risk to dealers is the volumes of cars they hold in stock.
“The question of the size of the loss and who incurs it always comes down to who is holding the baby when the crash happens. Motor retailers, whether independent or franchised, will always hold the risk with regards to the current vehicles they have in stock.
“Many of the independents proved that this can be successfully managed using fast stock-turn and they can still trade profitably during a slowdown. The franchised retailers have an issue with demonstrator vehicles and any guaranteed buy backs. And the franchises themselves have an issue with staff cars and promotional vehicles. The majority of the risk has historically, however, sat with the general consumer who bought the vehicle under the hire purchase system. Ultimately they had the issue with regards to the value of the majority of the vehicles, whether cash purchased or under hire purchase.”
For Jones, a real problem for some dealers is the very high levels of stock held by some franchises as carmakers strive for greater market share.
“With the advent of PCPs and their increasing penetration into the market, a lot of this risk has switched to the motor manufacturers and their associated finance companies, and this is the risk the Bank of England has recently highlighted. The retailers still have effectively the same risk as ever, albeit the levels of stock they are holding at the moment is, certainly, within some franchises, very high increasing their potential losses in any downturn.”
But Jones also points out that a potential fall of 30% flagged up by the Bank of England is far greater than that in 2008.
“It is important to note, however, that the drop in values being conceptualised at the moment is well in excess of any drop we have seen in recessions of the past. In addition, from a retailer point of view, there is an upside in the current situation. In the last recession customers chose to hold onto their vehicles once they reached the end of the finance agreement and enjoy a period of making no payments. This will no longer be possible as they will either have to finance the balloon payment or enter a new lease. This will provide sales opportunities for retailers,” he said.
Mike Allen, head of research at Zeus Capital, has tracked the performance of dealers in good and bad times. He said it’s reasonable to look to the past to see how a fall in used values would impact dealers in the future. But he does have one caveat. The market has changed dramatically since 2008 in terms of the data available to dealers and the way they sell cars.
“The systems in the businesses were not as good as they are now. All of the plc dealers know exactly what sort of cars they have got, where they are keeping them, they are tracking regional trends and they are focused on stock turn,” he said.
“Because they have more data at their fingertips they are just better at used cars. You can see that in the return on investment on used cars. Now I am not saying this does not make them vulnerable if the market slows down but I think they can cope better.”
But Allen concedes there is no getting away from the damage caused by falling values to the stock held by dealers.
“It is painful if residuals drop five per cent a month because you are taking the hit on your stock and you get panic in the market as well where people just want to get rid of the stock. It becomes self-fulfilling as the prices drop further and further,” he said.
So what is Allen’s take on PCPs and their current high penetration levels? First of all he suggests the salad days may already be over.
“Penetration levels are very high at the moment and that is predicated on strong deals that we have seen in the past. There is a question mark over whether these deals will remain as competitive as they have been.
“Having said that reports in the media have been overdone particularly when you look at the secure lending market where the number of write offs is extremely low. This is a market that has worked well for manufacturers to increase customer loyalty and it offers consumers great value for money.
“The ultimate risk is with the lender and those lenders are the manufacturers who have been using their balance sheets to fund these deals and to build market share. They have done the work and committed a lot of resource to working out the residual values. I think where the PCP would not work is if we got negative equity,” he said.