Manheim Conference Call Part 3: Upstream, Midstream and Downstream Remarketing

Consignors have been relying on auto auctions since the 1930s, so changing the mindset and the business practice of vehicle remarketing takes time. . . It's clear, however, that upstream remarketing is on the rise and quickly being adopted, based on its practicality and profitability.

- Julie Anders, vice president of strategy and delivery for Emercent Solutions, Vehicle Remarketing January/February 2004

Today I wanted to conclude my 3 part series that emerged as a result of Manheim's first quarter conference call. The first two parts focused on the new and used vehicle sales environments inspired by commentary Manheim's Chief Economist, Thomas Webb gave on the call. And part 3 focuses on this idea of upstream, midstream, and downstream remarketing.

You've heard me discuss for sometime the idea of the internet changing the auto retail environment. And I have talked about how used vehicle inventory management/optimization continues to evolve in the industry. While I have talked about the retail side of the equation, where dealers are putting in new systems and processes that allow them to better determine how to stock their lots (and this is a continually evolving process), there is similarly growing efficiencies emerging in the wholesale (so dealer to dealer market).

As today's opening quote suggests, up until the last 5 or 10 years, the way dealers procured (bought) used vehicles, was either from the trade-in (so when a customer came in to buy a new vehicle they "traded in" or sold their used vehicle to the dealership) or at auction. Auctions, which is this "downstream" remarketing made a lot of sense, and brought a tremendous amount of efficiency. Let me explain. . .

If a customer walked into a Ford (F) dealership, owned a Ford Mustang, and wanted to buy another Ford Mustang, the dealer would sell the new Mustang, and then buy the person's older Mustang. They would then offer the older Mustang (that they just bought) for sale on their used vehicle lot.

But what if a customer owned a Dodge Charger and wanted to buy a Mustang? Chances are (although it happens), the dealer would surmise that people in the market for a used Dodge Charger would not come to a Ford dealership. But the dealer didn't want to lose the sale of the Ford Mustang by sending the customer off to a Dodge store to sell the Charger (the Dodge store might have talked the customer into buying another Charger). So the dealer agrees to buy the Charger (even though he/she really doesn't want it) in order to sell the Mustang to the customer.

Stuck with this vehicle that he/she really didn't want, the dealer turns around and sends the car out to a local auction (run by companies like Manheim or Adesa). And Dodge dealers or at times other independent car dealers would watch the vehicle go down (hence downstream) the auction lane and bid on the vehicle. And likewise, the Ford dealer would probably be at the same auction bidding on used Mustang's that Dodge dealers had bought in their pursuit to sell Ford Mustang customers a new charger.

On top of dealer to dealer sales at auctions, were car rental companies, local governments (that wanted to unload things like police cars), and even banks and leasing companies. It simply was a convenient location to unload these vehicles. And it is these "fleet" (car rental companies, government agencies, and banks) where I think you are seeing the biggest change.

At the very least, the dealer and particularly a fleet company, doesn't need to physically go to the auctions (although many dealers still like to kick the tires). Dealers are able to watch (simulcast) the vehicles go down the auction lane and make bids from the comfort from their store (or home). On the conference call, Manheim said simulcast volumes are up 26% year over year "in a flat market."

But if I am a bank, government, or car rental company (and even a dealer), I start to ask myself, do I really need to spend all of that money, and risk damage to the vehicle shipping it off to an auction where it may not even sell? Keep in mind, sellers usually give a minimum bid value where if no one offers the minimum, it just doesn't sell.

For example, in the fourth quarter of 2006, Adesa had 696,000 vehicles run through their auction lanes. But only 412,000 of those vehicles actually sold. This means the other 284,000 vehicles did not meet the minimum bid. So you only have ~6 out of every 10 vehicles running through these physical auctions that actually sell. Otherwise the seller (dealer or fleet) is left taking the vehicle back and/or paying interest while the auction company holds onto the vehicle for the next auction.

And so it is the elimination of added costs associated with physically shipping the vehicles out to auction that may or may not sell that becomes so appealing with these "upstream" auctions.

Vehicleremarket.com, in discussing an Emercent study found that in 2004 something like 4 out of every 10 vehicles being remarketed by captive lenders (so like Ford Credit, GMAC, etc., that have gotten vehicles back from leases) are done through this "upstream" approach. And I can only imagine that the percentages are even greater today.

And now you have a new "animal," so to speak, which is this idea of "midstream" remarketing. This is where the buyers and sellers do not know each other. Of course, that can become a problem when it comes time to delivery of the vehicle and payment. You sold your vehicle to some independent dealer you have never heard of, and they don't pay. Or you buy a car from dealer X and right at the last minute a customer comes in the showroom and they renege on the sale. This is where Manheim feels they have a competitive advantage, where they can help bring some of this "security" back to the process. I'm not here to advertise for Manheim, I don't know if they are better than anyone else with this Midstream remarketing concept.

But I can tell you that the idea of midstream remarketing is a growing force in the industry. On the Manheim first quarter conference call, the head of Manheim's Online Vehicle Exchange [OVE], Jim McKnight, said that Midstream volumes, at least in the last couple weeks, were up something like 85% year over year (granted this is probably from a pretty small base). It just makes sense that the market becomes more "virtual," and reduce the physical back and forth where vehicles don't "convert" (the term technically is conversion rate) to actual sales.

The only limitation I see for growth in Midstream, and to a certain extent even upstream, is quality. How do you know what the quality of the vehicle is? Remember how I talked several weeks ago about how repair shops like Monro should begin offering free inspections? You've got folks like Midas already trying to target the fleet market more.

What I don't understand is why repair shops are not trying to work with the auction companies to create various "certifications" and standards in these online (upstream/midstream) remarketing initiatives? When it was physical auctions, it seemed like buyer beware reigned, because it was up to each and every dealer at the site to have the skillset to analyze quality. But now, it just seems like if there were quality assurances (like the vehicle had gone through a reputable repair shops inspection program or something) that upstream and midstream remarketing could really become "mainstream," and the entire market could become more efficient.

Manheim Conference Call: Reader Response to Part 1, how can supply determine demand? Would you like fries with that?

I also wanted to just make a few comments to a flurry of emails that came in regarding part 1. As you may recall, in part 1, I talked about how Mr. Webb was looking for vehicle sales by the automakers to rental car companies (Hertz (HTZ), Avis (CAR), Budget, etc.), to drop.

I think in total, Mr. Webb said the number of vehicles sold in January, February and March (combined) to rental car companies versus those same months in 2006 were down nearly 13%. And when we close the chapter on 2007, he said these (daily rent) vehicles are likely to be down 6% to 9% from the number of vehicles sold to rental car companies in 2006.

From Mr. Webb's comments about "daily rent," I made the case that a lot of the forecasts out there that called for modestly lower new vehicle sales (including my own) in 2007 therefore (by default) was based on the planned reduction in rental car sales by the automakers, not a drop in retail demand (the vehicles you and I would purchase walking into a Ford store).

Now a number of you emailed me with questions generally asking how automakers can make planned reductions in sales to the rental market. Aren't the number of vehicles SOLD TO the rental car companies DETERMINED BY the rental car companies themselves, not the automakers? Many of you asked. So if the domestic automakers view sales to the rental market as unprofitable, wouldn't this just mean the rental companies are likely to be successfully courted by the foreign automakers? How can supply determine demand?

I'm glad you asked. Because it really illustrates this idea of "demand creation," that I have talking about for some time. Think about a value meal at a fast food restaurant. I may not want those French fries, but since the hamburger, French fries, and soda cost about the same as just the soda and burger, I end up with the fries too. And the same thing happens in the auto industry, where buyers may not need, or even necessarily want the product, but the offer becomes so compelling, that they end up with it.

For many years now, from what I understand, rental car companies were offered "program cars." Essentially this meant the domestic automakers would guarantee the value of the vehicle when the rental car company was done using it (although this can come with conditions like that a customer has to buy another car from the automaker).

As a result, even though the rental car company could have held onto the vehicles longer, it simply did not make economical sense. They could unload the one or two year old vehicle and get a brand new one. So the vehicles would get dumped out into the wholesale market (auctions where dealers would buy the vehicles) creating a fair amount of supply, and thus keeping used vehicle prices (residual value) for these products low.

As the automakers offer fewer program cars, and instead sell "risk vehicles" (meaning the rental car company takes the risk when they go to sell the vehicle at auction) it now makes sense for rental car companies to hold onto their vehicles longer. And there is a great precedent (example) of aggregate (total) demand dropping when vehicle manufacturers ease back on guaranteed residuals with the class 8 (so big rig truck sales) market back around 2002. Freightliner (who sold nearly one out of every three class 8 trucks) similarly reduced/backed away from guaranteed residual values for those vehicles.

Consider the following snip it from an article by Rick Weber in Trailer Body Builders on April 2, 2002 where he reported on a speech given by HC Wainright and Co. equity research analyst Eli Lustgarten at the World Truck Show's education program:

God bless Freightliner and guaranteed residuals," he said. "Wonderful market, but the other side of it is a disaster. What's the estimate of excess trucks in the used market? Most say 100,000 trucks sitting there called "used trucks looking for a home." Freightliner is trying to walk away from guaranteed residuals. They're still in the market, but they're not at 40% - they're at 20%. If you bought an $80,000 truck and had a guaranteed residual of $40,000 over three years, at 400,000 miles, that's 10 cents a mile. Today, they'll only guarantee you $20,000 residual. So now it's $60,000 it'll cost you over three years at 400,000 miles, but it'll be 15 cents a mile. How do you make 10 cents a mile? Keep the truck another year longer.

Now this is not entirely comparable, because the rental car market is not faced with eroding used vehicle values (they are actually steady). And to a certain extent the rental car companies are just shifting how they purchase the vehicles. As one industry participant emailed me "they just transition to a 'retail' buy directly from the dealers."

But the automakers are clearly changing the attractiveness of program cars. Think about what Hertz said (in the company's press release) when they released fourth quarter results:

The Company notes that its 2007 model year unit car costs are expected to increase by less than 6% in the United States due to a shift away from purchasing cars under manufacturer repurchase programs, with such vehicles expected to represent less than 40% of all car rental fleet purchases for the 2007 model year.

And that compares with something like 52% (so 1 out of every 2 vehicles) of Hertz's vehicles in 2006 being under these manufacturer repurchase programs (so program cars), and 74% in 2005 (so 7 out of every 10).

I should add that a 6% car cost increase expectation is dramatically lower than the 17% year over year increase I guess they saw in 2006.

The manufacturers are changing the attractiveness of these "program cars" and this is causing the rental car companies to re-think their vehicle procurement (purchase) strategy. Here are some quotes I jotted down during the Hertz conference call:

Fleet costs are about a third of all costs.

Environment a little brighter in 2007.

Extend holding periods.

Change process so we can get better utilization of the fleet.

The bottom line: when you stop throwing in the fries with the meal, some people don't order the fries!