It only takes a few minutes to browse headlines and articles covering the automotive industry to turn your smile. The main manufacturing plants of car manufacturers such as Ford (NYSE: F) and General Motors (NYSE: GM) halted vehicle production and analysts predict billions of dollars in losses as consumers avoid expensive purchases such as vehicles, and social distance keeps pedestrian traffic away from showrooms. In other words: business in the automotive industry was brutal during COVID-19.
But there is one factor that investors may have overlooked that could also cripple the major automakers: plunging prices for used cars. Sounds weird, doesn’t it? Here’s exactly how and why used car prices impact Ford and GM, and examples of their severity.
Financial weapons 101
If all you know about Ford and General Motors is that they mainly make and sell vehicles, you are not to blame. But a competitive advantage that these car manufacturers have had, for different durations, is their financial arm: Ford Credit and General Motors Financial (GMF). These financial arms are essential for automakers because they help consumers finance their vehicles, rent vehicles, and help dealers. Better yet, these financial arms are extremely profitable for automakers most years. In the graph below, you can see that Ford Credit generated almost half of Ford’s pre-tax profit throughout 2019.
Outside of the lucrative Ford region of North America, Ford Credit generates more pre-tax profits than its operations in South America, Europe, China, Asia-Pacific and the Middle East and Africa combined.
The GMF posted a similar return: the GMF generated $ 2.1 billion in pretax profits in 2019, which was more than its unprofitable international operations and much of its total $ 8.4 billion. This is how important Ford Credit and GMF are to their respective automakers in Detroit. When business is solid and stable, financial weapons are an incredible trick in automakers’ sleeves for higher profits – until the rare year when a rapid slowdown can hurt their bottom line. So how would falling car prices impact their financial arms and how dramatic could the negative impact be?
Misfortunes excluding rental
When a consumer rents a vehicle from Ford Credit or GMF, the financial entity estimates the return value of the car expected at the end of the lease. In most scenarios, this happens with little adversity and the financial arms generate a welcome profit. However, when something drastic happens, such as a COVID-19 disruption, which plunged car prices, the values of returned vehicles are significantly lower than estimated, sometimes causing heavy losses for the financial arm. Automotive news reported that wholesale values were down between 10% and 12% as the inventory of used and non-rental vehicles increased, and there were fewer bids and less demand. How much could it affect Ford Credit and GMF, you ask? Let’s take a look at the last time Ford Credit suffered losses when used car prices plunged at the start of the financial crisis.
Ford Credit suffered a loss of almost $ 2.6 billion in 2008, and JP Morgan Analyst Ryan Brinkman wrote in a report that if prices fall 10% in the second quarter, total losses could reach $ 3 billion at GMF and $ 2.8 billion at Ford Credit.
What happens next?
Yes, this is a rough scenario for financial weapons such as Ford Credit and GMF, but it is also bad news for rental fleets, such as Hertz and Notice, as well as used car dealers like CarMax.
^ SPX data by YCharts
But there are levers that can be pulled to help offset some of the negative impact felt from falling prices for used cars. Note in the graph showing Ford Credit’s results: the 2008 losses quickly reached a lucrative profit in 2010. Part of this was due to the cash-for-clunkers program, which helped reduce the surplus of cars considerably. opportunity and to balance supply and residual values. In addition, some car manufacturers already offer lease extensions to their customers. These measures essentially buy the financial arm’s time before it has to record the return value of a car, which could mean better prices on the road.
COVID-19 and Falling Used Car Prices Will Slow the Auto Industry, But Big Car Manufacturers Like Ford and General Motors Should Have Liquidity And Ability To Offset The Negative Impact Enough To Survive and focus on their long-term strategies. However, this reminds investors that seemingly unrelated factors, such as used car prices, could have a detrimental effect on a business that primarily sells new vehicles. This is a great example of why investors should continue to learn, read and understand the companies in their portfolio.