You see, dreamers are the persons who are responsible for putting us on the moon. Dreamers invented the automobile; dreamers invented the interstate highway system. Dreamers are the people who are moving our world foreword. And people who do not like dreamers are the ones who refuse to change, adapt or accept that their might be a better way.
- Larry Edwards, Edwards & Associates, Fixed Operations Digest (volume 55).
Housing market problems: 1) Flat out bad things 2) Bad things that create an opportunity
I am sure you have been hearing a lot about all of the problems in the "sub prime" housing market lately. You've heard my rant about how problems in the housing market should not be used as an excuse for missing numbers. But I don't think my little peeves should be mistaken as saying there are never bad things that happen in the economy (dictionary.com: resources of a community).
There are two types of bad things that happen; 1) flat out bad things, and 2) bad things that create opportunities. Flat out bad things are diseases like Cancer, or structural or regulatory shifts in an industry that cause society to become less efficient. I have said determining if it is #1 or #2 is not always easy, but if the end recipients (the customer) end up the loser, it is probably a flat out bad thing. The other kind of "bad thing" is actually a "blessing in disguise," if you will.
So what is a housing slow down #1 or #2? While the person unable to make their monthly mortgage is truly experiencing something bad (personally), I must come across with a somewhat cold "economic" minded answer: underlying demand for goods and services (including the demand for houses) will ebb and flow.
No matter how good you are at planning (government or business), you will never be able to completely align all of society's resources with what society needs at a given point in time. So, as part of this "balancing" process, producers of goods and services and even economy's (simply the resources of the community) go through cycles (dictionary.com: a periodically repeated sequence of events).
And yet it is during the downturns (ebbs) in these repeated sequence of events (cycles), I would argue is when some of the greatest GOOD can happen. During "good times," people tend to overlook inefficiencies. For example, let us suppose on Tuesday a dealer had 100 people walk into his/her showroom. Yes, every customer is important, but if you can get 10 of those people to buy a car, you are probably pretty happy. Now imagine on Wednesday only 10 people walked into your showroom? How important is each customer on Wednesday versus Tuesday?
See what I am getting at? When there are a lot of people, overlooking or losing a customer might not be a big deal on Tuesday. But on Wednesday, every person that walks into the showroom is more important than gold! You start to ask yourself, how can I serve this customer better? If they aren't going with me, why? Was it price? Service?
And so downturns expose the weaknesses of an organization. The things that you have been able to "let slide" because frankly you were making enough money despite these deficiencies. "That which does not kill you only makes you stronger" my old high school swim/dive team shirt used to read. Downturns cause the weak to either get better, or go away. And the folks providing the most efficient means of distributing or servicing the customer tend to come out of these periods bringing a better value proposition (price, service levels, etc) to the customer.
So whenever you hear about some "macro" dynamic occurring in society, I think we need to ask ourselves two important questions: 1) does this impact my customer? and if so, 2) WHAT AM I GOING TO DO ABOUT IT? Because I really think any time an ebb (versus a flat out bad thing) occurs in the economy (society's resources) it creates an opportunity.
Does the housing weakness impact my customer? I think it is only like 2%
Let's go step by step here. First of all if I am a buy here pay here dealer, I think the answer you will find pretty quickly is that a downturn in the U.S. housing market should not have an impact on buy here pay here customers (deep subprime). Skip Falgout, CEO of America's Car-Mart (NASDAQ:CRMT), addressed this issue last week on the company's conference call. Buy Here Pay Here customers are already credit strapped, which means (from what Mr. Falgout indicated and I think he is right) that most of these customers do not own a home.
The National Association of Realtors First-Time Homebuyer Affordability Index pegs the qualifying income at a little more than $52,000 a year. When you consider the census bureau's 2005 U.S. household median income of a little over $46,000 a year, you can see why the average American has struggled in buying a house (as of late). And so the credit challenged customer (like buy here pay here customers) are likely to fall into the rent category, not homeowners. Incidentally, this "correction" is therefore also GOOD in the sense that it is making housing once again affordable to the average American (prices were just getting out of hand).
What about new vehicle customers? If we just think about the number of "sub prime" new vehicle customers, it is probably not a big impact. During General Motor's (NYSE:GM) sales conference call, Paul Ballew, GM's head of sales analysis indicated sub prime might only be something like 5% of the overall new vehicle market. More than one out of every two vehicle customers (ala CNW and GM) have household income over $75,000 a year.
However, the real question becomes how many people that were once categorized as "prime" become "subprime" because of the implosion in the housing market? Well, for that I think we need to step back and think for a moment about what is happening in the housing market, and therefore who is really being impacted.
No, I am not going to take you back to consumer price index "hedonics" and how there are too many dollars floating around causing various "bubbles" in the U.S. economy every few years (equities in the late 1990s, the housing bubble today, and probably a commodity bubble by the end of the decade). Those of you that have been with me for a while are well familiar with my opinion on this topic.
I think we should simply accept the fact that the housing market experienced a pretty solid "boom," and now the boom has busted (or is correcting depending on what terminology you wish to use). I will leave it to the experts to debate how severe and long this "correction" will last.
But I do think it is helpful to remember what happens in a bubble. On September 26, 2006 when we talked about bubbles, I said that while it might be difficult to prove excess capital causes irrational actions, one thing is for sure. . . all of the bubbles I have studied seem to result in people acting irrationally. Specifically, they buy (invest) in assets that are not based on the fundamental (the return that should be received).
Instead, one of the biggest traits noticed was an emphasis by the investor not on the value of what they were receiving, but in the hopes of being able to sell the asset to someone else at a higher price.
In fact I began the September 26, 2006 informer with this thought:
The lesson? If you take nothing else away from these emails (and website), please take this: trying to play the bigger fool game (that is buying an asset in the hopes of being able to sell it at a higher price to a bigger fool), is not only unwise, it may signal a bigger underlying problem.
And so we seem to be in the midst of correcting from too many speculators that bought in the hopes of being able to sell real estate to "a bigger fool." The speculators are now getting washed out of the market, and over time demand (for housing) will come back into balance with the supply.
Beyond the speculators (which are seeing their business go bust), I don't see the vast majority of American vehicle buyers impacted by the housing downturn, aside from being able to pay a more reasonable price for a home. Think about it this way. There are roughly 75 million homeowners (according to Alphonso Jackson, Secretary of Housing and Urban development in 2005). Sure, the value (on paper) of your home went down. But you continue to live in the same place, pay the same monthly mortgage, and life doesn't "feel" any different because the "gains" were all on paper anyway.
The concern comes for the people that more recently financed their homes with things like "interest only" variable rate loans, which an article in the New York Times by Damon Darlin in July 2006 indicated was about 26% of all loans in 2005. But keep in mind you have roughly $700 billion worth of loans that were reset in 2006 out of an estimated $11 trillion in home equity (according to the New York Times article), which I calculate is therefore only about 6% of these 75 million homeowners (so a little under 5 million people).
And as I have discussed in previous articles, American's tend to turn over their vehicles (new and used) every four years. So in the grand scheme of things, using this very back of the envelope analysis, it suggests only about a million people who actually buy a new or used vehicle every year are actually the folks that are seeing their monthly mortgage payments go up (from the loan resets).
Remember, American's buy 60 million (new and used) vehicles a year. One million out of sixty comes out to only about 2% of vehicle buyers. For these individuals, the impact is very real. But for 98% of the American vehicle buying population, it seems like the only impact the housing market could have on their vehicle purchase decision is that they "feel poorer" because on paper their home equity has gone down. And I am not sure how we can measure "feeling poorer" influences vehicle purchases. Although I'd encourage my friends at CNW or JD Powers to try.
Also, the U.S. equity markets are at record levels. So a potential offset are the number of American's that "feel richer" because their stocks are up. And this is why I think the "housing problems" as real as they are, are likely having less of an impact than people think on overall vehicle demand. I still think over saturation from "demand creation" done by the automakers over the last decade (from massive incentives), and the ability for the automakers to now back off a bit (on the affordability side) as "manned capacity" comes down, can cause a greater impact on the demand side than the housing market. Something the industry is frankly just going to have to brace itself for in the coming years.
What are you going to do about it? Why not use this as an opportunity to begin showing the REAL cost of owning a vehicle
Importantly, what if people are right? What if 10%, 20%, heck even 30% of the U.S. vehicle buying consumers were finding it more difficult to buy a new or used car because of the housing downturn? The real question is what are you going to do about it? How are you going to help these customers that clearly are having trouble with their finances?
This is the real question. I think the problems in the housing market create a rare opportunity to start a dialogue with customers about the REAL cost of a vehicle. Think about what happened in the housing market. Consumers got stuck in these interest only variable rate mortgages because they were focused on the monthly payments, and not realizing they were setting themselves up for bigger problems down the road.
It is not that they are stupid. Last year I wrote about behavioral finance and talked about a University of Chicago and MIT professor's paper that stated three limitations in consumer finance/economic decision making. One of the limitations I talked about was "bounded" rationality. We don't always make rational decisions. Not because we are dumb, but because we create general "rules of thumb" particularly for things that are not our "core competency."
For most people the idea of "finance" is like taking a trip to Mars. It would be like asking me for medical advice. I'd tell you to take two Tylenol and call a real doctor! In the same regard, many people apply general rules of thumb with financial decision making. One of the most prevalent "rules of thumb" (particularly in today's society) is the monthly payment focus. These consumers were told $1,100 a month (for example) to buy a home, and to them that fit into their budget. Some of them were even told about the "cash on cash" return on investment opportunities because housing prices continue to soar (so you should be able to sell it to the "bigger fool" in a few years for more than what you paid for). Sound familiar?
And as the dialogue builds in American society over the next couple years about how homeowners and even the speculators didn't understand the REAL costs and risks of the property, I think it creates the perfect opportunity for auto retailers to begin a dialogue with customers about the REAL cost of a vehicle.
You've heard me talk in the past about how right now dealers get caught in the "monthly payment" game because everyone else in the industry is talking monthly payments. Imagine trying to explain to a customer they should buy the Chevy Cobalt for $370 a month versus the dealer down the street that is offering a Chevy Monte Carlo (which is over 50% more in invoice/retail costs) for a similar ~$400 a month payment. Of course in order to get the Monte Carlo for ~$400 a month they have to make payments for seven or eight years versus the five years for the Cobalt. But to the consumer, they are monthly payment driven. Now are you ready for the curve ball? Maybe the Monte Carlo isn't as bad of a deal as it sounds for the customer!
FleetCentral has an "all in," or life cycle cost of the vehicle. Intellichoice (kind of the pioneers in the field) similarly has the REAL cost of the vehicle. What do I mean by the real cost of the vehicle? What the entire cost of ownership is, which includes everything from depreciation, financing, insurance, state fees, fuel, and repairs. So for example, going to Intellichoice's website, instead of the "cost" of the Chevy Cobalt simply being the $13,390 (invoice) or $14,170 (retail), when you add the ~$8,841 in depreciation, $2,339 in financing (interest) costs, $7,642 in insurance, $293 in state fees, $6,907 in fuel, $1,339 in maintenance, and $415 in repairs, the "all in" ownership cost of the Cobalt over a 5-year ownership period is $27,776. The Monte Carlo, using this same analysis comes out to an all out ownership cost of ~$33,893, not nearly the 50%+ difference in costs when you evaluate these two vehicles solely on invoice or retail prices.
Now just imagine if an electronic menu provider or an auto retailer (I think this idea would work great with AutoNation's (NYSE:AN) Smart Choice) were to take this "all in cost idea" either from Intellichoice, the competitors that are powering Fleetcentral's system, or even developing it themselves, and then converting it from TOTAL costs, to what it works out on a monthly payment basis. I can tell you I encouraged James Bell of Intellichoice to create such a "monthly payment" calculation when I sat down with him over coffee at NADA. Who knows if they will develop such a "product." But let's do it ourselves right now with the Cobalt/Monte Carlo example. 5-years equates to 60 monthly payments, which given the Intellichoice "all in costs" (I quoted above) works out to $463 a month for the Cobalt, and $565 a month for the Monte Carlo.
This is the opportunity, the dialogue, if you will, I see potentially emerging for leading (customer centric) minded auto retailers. Being able to sit down and say to Mr./Ms. car buyer, the problems you see happening in the housing market is because people weren't explained the REAL costs of ownership. So here it is. Sure, technically, you are going to write a check to GMAC (or some other financial lending institution) for some $370 a month for this Cobalt. But when you take into consideration things like depreciation, fuel, and maintenance, it is really costing you about $463 a month.
Now I need to point out another part of behavioral finance/economics. In addition to bounded rationality (meaning limitations to consumers making rational decisions because of "rules of thumb" like monthly payments), there is also "bounded willpower." This means sometimes we (as consumers) know we are not making the best or most rational decision, but we decide to do it anyway. I knew walking into Cold Stone Creamery this weekend that buying that fudge brownie delight was not the healthiest or most rational decision, but I went ahead and did it anyway.
You can not stop irrational decisions from happening, and from time to time they are even ok. But consumers at least deserve to have all of the information put in front of them in helping them make this rational decision. This is the opportunity I see emerging from the housing debacle. The ability for auto retailers to begin a dialogue on the REAL costs of owning a vehicle.
Anyone can give you a housing report and focus on the "excuse." But I think cutting edge auto retailers will focus on the opportunities. The "all in cost" idea I have just discussed is probably nothing compared to what smarter people than I can think of to help customers when an "ebb" occurs in the macro environment. This is what I look forward to hearing about on future conference calls. How auto retail management teams plan to help their customers given this weakness in the housing market.