Economic Austerity and the outlook for UK Motor Retailers.

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Balenciaga

It was at the start of 2009 that luxury brands – LVMH, Burberry, Bulgari, Chanel, Balenciaga – first reported ‘luxury fatigue’, where buyers report that conspicuous consumption becomes an embarrassment. It is more than the fact that demand for allotments is at a record high or that spending in the haberdashery department at John Lewis is up 20%, after decades of decline, as we all make do and mend. Canny retailers all report the emergence of a new customer attitude – saving, not spending, as fear of unemployment and high credit costs become the norm. As a result, the July 2010 Nationwide Consumer Confidence Index fell to its lowest level since May 2008.

While the ‘wannabe rich’ are cutting back, the mainstream customer, whose disposal income is falling 2% a year, has almost halted discretionary buying. What might that do for car retailing?

The pinch points for car retailers are the same as other retailers, but worse, because their margins are so slim. First is the top line – any negative impact on turnover; then comes costs; and finally, collateral (i.e. property values). They’re often highly geared, so falling asset values restrict their ability to borrow and maintain cash flow in the troughs of a highly seasonal business.

Turnover

Predicting revenue is problematic because car retailers face real difficulty finding data on emerging consumer trends. Depending on franchise, their customers can range from overwhelmingly retail customers – making a discretionary purchase from taxed earnings – to mostly business customers ordering a replacement working tool. In either case their communications with them are infrequent. They need sharp antennae to measure their customer’s pulses.

For sure, the retail outlook is unwelcoming. The UK government intends to cut spending by £130BN in 4 years. The easy targets are going first: The UK Film Council, The Health Protection Council and the £55BN School Rebuilding Programme. But many private firms are also in the firing line: Southern Cross Healthcare will see fewer local authority funded admissions; construction companies with government contracts will see a slowdown; social housing maintenance group Connaught are in emergency talks with its banks as cash dries up; shares in Cable and Wireless are down around 25% on news of the government’s cuts; ‘Carpetright’  reported “no recovery in sight” for consumer spending following three months of falling sales to the end of July 2010. Some of these organizations have previously weathered the economic storm and have propped up last year’s spending. So, their recent difficulties show how deep the problems are now going. (See the LGA White Paper “Getting Through the Recession“)

The UK Coalition Government’s hope is that export-led private sector growth will substitute for the fall in government spending. But where is the UK to sell its wares? While the latest German economic figures report 2%+ growth in GDP in Q2 2010, the forecast from the European Central Bank (ECB) is that Eurozone economic performance will be below trend until mid 2012. 1.1% in 2010, 1.4% in 2011 and 1.6% in 2012. At present the pound is stronger against the Euro than at any time before November 2008, which will also hamper exports to the Eurozone. The US Commerce Department only predicts slightly better figures for the US and recent reports suggest a slowdown in Asia. With this scenario, exports are unlikely to come to the rescue.

According to the UK Insolvency Service, the rate of Motor Trade related company liquidations – compulsory and voluntary – both fell sharply in H1 2010. However, this probably reflected the benefits of the additional cash flow generated by the 2009 Scrappage Scheme, rather than a change in financial fundamentals. While there may have been some high profile failures, many dealers proved to be resilient in the last two years assisted by improved used retail residuals, cutting overheads and pay and, most importantly, manufacturers bringing supply and demand into better balance, allowing mainstream dealers to earn target bonuses. Even so, the estimated UK franchised dealer numbers in 2009 were no higher than 4,500 – 4,700, down from around 5,100 in 2008.

The SMMT currently predict (July 2010) a 2010 UK car market of 2.02 MN registrations, broadly in line with 2009. On these estimates another 150 dealers will be forced to close in 2010. However, for every additional 1% fall in registration volumes another 45 – 50 dealers will be surplus to manufacturer’s needs.

Costs

Dealers have long recognized both their vulnerability and importance in the supply chain: they are important because the best dealers ‘wrap’ the customer in personalized services which ensure loyalty to the brand. Services that manufacturers find hard to copy or substitute; they’re vulnerable because they account for 8% to 12% of total supply chain costs – double that if you add the wholesale distribution and marketing costs. As manufacturers squeezed suppliers in the last two decades, there is little more to be gained at that end of the chain. As far as many auto makers are concerned, dealers still have potential to reduce costs. Typically dealer’s costs are already 97% – 99% of total revenue, yet some manufacturers’ ambitions involve even higher costs for dealers in facilities, staff and infrastructure. For example, the success of Hyundai and Kia in the last two years has resulted in calls for their dealers to separate their showrooms. Just a few years ago Hyundai and Kia were ‘fill-in’ brands that established players tolerated because they posed no threat. Now they are seen as direct competition to mainstream brands.

Property

IPD UK Property Index Trends to 2010Commercial property values are essential to many dealers as overdraft facilities are often linked directly to the equity available in their freeholds. Dealers with freeholds could be forgiven for believing that the recession was over when they learnt that cash was flooding into commercial property funds in the second half of 2009. Returns of 18 – 25% were being quoted after years of losses. They would have been dismayed to learn later that, while property values had turned the corner, this was new money seeking to buy commercial property at ‘bargain basement’ prices, not necessarily an uplift in the value of their own premises. In 2009, retail property continued to fall in value, IPD recorded a drop of -2.4% in capital values, although rental incomes rose. Up to Q2 2010 capital values have risen by 1.9%, which is positive news.

Share Prices and Conclusions

Pendragon SP to 18 Aug 2010

My advice to most retailers would be to watch the trends in the share price values of retail dealer groups such as Inchcape, Vertu, Lookers and Pendragon. Lookers Half-Year Report showed a healthy increase in margin and cash flow, but only raised the share price from £0.54 up 3p – and within a fortnight it fell back down again. Inchcape fared better rising from £2.35 to £3.20 on rumours of good Interim Results, which proved well founded. However, the market has since dropped back to £2.70 as speculators took their profits. Vertu Motors have yet to file their Interim Report (available 31/08/2010) and the shares have drifted steadily downwards from £0.38p to £0.28p on the absence of any news. Their novel strategy of buying distressed businesses for less than asset value worries some observers, concerned that they don’t have the management capability to engineer turn-arounds as quickly as they can buy them. Pendragon continues to drift down, despite an impressive Interim Statement.

Unless shares in at least some of these groups begin to rise, representing as they do a wide cross section of the industry in terms of brands, geographical range and strategy, I suspect that investors fear that there will be little to cheer about for many UK motor retail dealers between now and Christmas.

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