As the economic cycle extends, North American vehicle unit sales continue to exceed forecasts, buttressed most recently by a renewed enthusiasm for light trucks and SUVs. Yet, the most successful dealers are positioning for a future that includes profitability pressure with rising expenses, higher floor plan carrying costs, increased manufacturer demands and consumer reticence in the face of rising interest rates.
Both large and small dealers understand that they can’t control interest rates, but they can act to hedge their exposure. Forward-thinking dealers, already on their second or third round of expense reviews, are taking the following steps to minimize their risk and hedge against headwinds in a higher rate environment:
Educate your consumers about financing
More than 80 percent of new vehicles sold in the U.S. are financed.[i] That means that the monthly payment amount is the primary measure of affordability for potential buyers. A rising rate environment has the potential to frighten off customers who don’t understand that monthly payment bump from a 25-basis point rate increase is minimal. Helping customers understand this fact, whether through social media, traditional advertising or point-of-sale material, can help you close more budget-conscious buyers.
Control operating costs
“A lot of dealers have been through so many economic cycles, they know this elongated recovery can’t go on forever. The big conversations we are having are about how they can get ahead of an economic turn by tightening their belts now, looking for ways to shave off SG&A (selling, general & administrative expense), renegotiate contracts, anything we can help them do to hedge and compensate for a rate environment they cannot control,” says Dennis Stough, Commercial Dealer Services Senior Vice President at SunTrust.
Cost-cutting and smart budgeting provide short- and long-term relief for stressed margins. Steps include:
- Complete an expense review by benchmarking costs and targeting saving opportunities
- Scrutinize non-strategic costs looking for expense reductions that wouldn’t hurt your core goals of selling and servicing your customers
- Improve controls on all expenses with automated online banking tools, expense category and employee level workflow approvals and regular tracking through flash reports that measure cash, profits and net worth
- Move accounts payables from paper to electronic with SunTrust Corporate Purchasing Card:
- Provide immediate settlement via card to suppliers and vendors
- Extend days payable with monthly billing
- Receive cash rebates if contracted spend targets are met
- Streamline the procurement and cash management process
- Offer a platform for reporting and expense control
- Consider upgrades to payroll processing. Eliminating remaining sources of paper checks can reduce fraud exposure. Newer software has substantially improved tax reporting which could cut some accounting costs.
Hedge through financial actions
Locking in rates should be a top priority. Dealership debt falls into three general categories, Floor Plan, Real Estate and Blue Sky, not all of which benefit from fixed-rate solutions. Different hedging options can be applied to all three aspects, but actions become much clearer once you have solidified your dealership’s long-term plans.
“Life cycle stage becomes important to discussions around hedging. Strategies differ dramatically depending upon a dealership’s or group’s plans,” explains Gregg Langhoff, Director, Financial Risk Management at SunTrust Robinson Humphrey. “Dealerships in growth cycles, possibly a turnover from parent to child or an acquisition strategy to stay competitive, would benefit from leaning more toward fixed rate options to conserve cash, then rebalancing later with a partially fixed, partially floating model, whereas more mature dealers may be selling off some or all of their assets, reducing debt and looking to protect that sudden liquidity.”
Consider these strategic actions for dealership debt:
Floor plan: Strategically manage vehicle inventory. Since floor plans are usually floating rate obligations, shifting your inventory mix to faster-moving vehicles, or reducing total on-the-ground units and slowing factory orders, can alleviate pressures from rising rates. The fundamental challenge with inventory control – even more so in a rising rate environment – is balancing unit levels with demand. Leaving your dealership short-stocked has the potential to backfire if you can’t put the customer in the right vehicle for a test drive.
Real Estate: Real estate has become an increasingly important piece of many dealers’ portfolios, increasing the value of the business and blue sky multiples dramatically. “As appraisal values rise, dealers that own their real estate can take advantage of locking in long terms rates to protect themselves from a rising rate environment, create certainty as to what that debt service payment will be, as well as utilize an interest rate hedge,” adds Mr. Langhoff.
Blue Sky: Acquisitions can leverage your existing infrastructure, with growing dealers taking on blue sky debt of the franchise they are buying. Because this valuation “allowance” is normally short-term in nature, many organizations choose to use a floating rate structure, paying the debt back quickly with free cash flow as soon as possible. Other, more growth-oriented companies may choose a more fixed option, paying the debt according to the financing institution’s requirements in an effort to conserve cash for a future purchase.
As the industry consolidates, dealer groups have begun exploring more flexible capital structures. Where once a single lender relationship could handle all a dealership or dealer group’s capital needs, rising real estate values, manufacturer facility requirements and image compliance demands now mean more capital including greater debt. Syndicated financing offers multi-year capital commitments with a large investor base that allows for growth accessed through one lead lender that coordinates all credit needs. While larger-scale groups are the most common users, forward-looking small to medium dealer groups use syndicated financing deals to stay ahead of capital needs.
Financing structure comparisons
Traditionally, dealership financing relationships centered around single lender relationships, with groups in need of larger capital cobbling together multiple lender relationships on their own. Now, syndicated financing offers a single lead lender to coordinate an expanded credit facility. The following chart outlines some of the most important benefits and considerations of each financing structure.
“The automotive space is extraordinarily capital intensive, and because of this, it’s leveraged,” says Mr. Stough “Dealers are borrowing on floor plans, on big facilities, on capital expenditures, and when there is M&A occurring, that equates to leverage, using debt to make these acquisitions.” Mr. Stough further explains, “Sophisticated dealer groups are using many strategies, including syndicated financing, to try to hedge and structure the balance sheet in future cash flows to make sure they can control their cost of capital for the short and long-term.”
Make a rising rate environment work for your dealership
Many dealers are getting ahead of rising rates and making financing, marketing and operations changes that will allow them to succeed in a world of more expensive capital.