Last month, Ford announced a plan to launch a separate brand for its electric vehicles business. The announcement was met with speculation from industry participants who felt Ford was planning to bypass dealers and sell directly to consumers, a concept popular on Wall Street. Ford’s CEO, Jim Farley, downplayed this scenario but hinted that major changes were coming to the automaker’s dealership network. Whatever Ford’s intention, it’s important to understand why it’s unlikely that incumbent automakers can afford to bypass dealers if they wish to survive the EV race.
Wall Street pushing direct sales to consumers is not new. In January 2000, Gary Lapidus, a well-known analyst with Goldman Sachs, promoted the idea with a highly-publicized report titled “Gentlemen, Start Your Search Engines.” He wrote, “the direct relationship with consumers will drive powerful new revenue streams” and forecast that direct sales would come via the Internet soon. But just a few months later, GM shuttered a plan for direct sales after realizing it couldn’t afford the idea. In 2001, Ford sold its automaker-owned stores, named the “Ford Auto Collection,” after the manufacturer lost market share in each region the stores operated in. Later, in 2006, GM ended another failed experiment to sell a Brazilian vehicle, named the Celta, directly to consumers via the internet. And in every market around the world, including those without dealer franchise laws, nearly all automaker-owned stores have been sold to dealers. But despite past failures, many investors are again pushing the notion of direct sales as beneficial to automakers.
So, what’s different this time? TESLA. The EV maker’s speculation-fueled stock price has drawn the awe of Wall Street, and many investors are pushing automakers to emulate anything the company does, including selling directly to consumers. TESLA’s market cap exceeds the market caps of all the global automakers combined. GM, Ford, and others trade at 4–5 times their net earnings, whereas TESLA trades at a valuation of 22 times its sales (GM and others trade at less than 1 times sales). These enormous differences in valuations are critical because they translate into cash constraints for the incumbent automakers.
Automakers have already lost billions of dollars, and will lose billions more, in the transformation from manufacturing profitable gas-powered vehicles to money-losing EVs. To succeed in the EV race, they need to invest in EV assembly, batteries, and nascent technologies – cash-heavy investments with a short shelf-life. These investments will continue to damage automakers earnings and therefore lower their stock prices, which means less access to cash. And if automakers wish to sell direct to consumers, they’ll need billions in cash to build their own retail networks.
Dealers provide significant cash-related benefits for automakers. For starters, dealers own, build, and staff sales facilities, which cannot be replaced with online-only sales. TESLA attempted to eliminate sales facilities when it announced an online-only plan, and then it retracted the idea immediately after. While the company sells many cars “online,” it benefits from wealthy buyers with prime credit, who can buy a vehicle with more ease than the typical car buyer. But most car buyers do not want to buy a car solely online.
For most consumers, buying a car is the second largest purchase they’ll ever make, with a house being first. They want to see the difference between vehicles; they need to test drive them, see if their family fits into them, and gain assistance with financing and trades. And when every automaker makes electric vehicles, in-person experiences will become critical to differentiate the vehicles amongst multiple makes. Thus, automakers still need physical locations to sell cars – and they also need them for service and repair.
TESLA is the second-worst rated manufacturer for vehicle quality and is the subject of multiple vehicle safety investigations. TESLA owners needing a service visit should expect long wait times; that is, if they are lucky enough to have a TESLA service center near them. And with TESLA’s at-home Ranger service limited to simple repairs, it’s clear that a nationwide service physical footprint is necessary for automakers. Hiring trained technicians and service staff, building compliant facilities with multiple service bays, and inventorying a full parts catalog are multi-million-dollar investments that dealers make in each service location they operate.
Caption: To replicate a sales and service network, in scale, would cost automakers billions; never mind the need to overcome retail learning curves that may take years. In Ford’s case, it has over 3,000 dealerships in the U.S. that sell and service Ford vehicles. TESLA’s 150 service and 200 sales locations are insignificant in comparison.
In addition to sales and service facilities, dealers provide automakers with financial liquidity. As soon as an automaker starts production of a vehicle, it’s paid by the dealer. In contrast, TESLA is paid when it delivers the car to its buyer. Dealers also finance the automaker’s new and certified used vehicle inventory, and parts inventory, with the dealer’s local banks. And dealers are responsible for the depreciation risk associated with the vehicles they own, which significantly reduces balance sheet liabilities for automakers.
Caption: Dealers are the “cash bag holders” for automakers as they are responsible for the cash requirements of retail operations, including sales and service, as well as the liability associated with used and off-lease vehicles.
Due to their role with used cars, dealers play a leading role in preserving the value of new cars. Many automakers depend on their used vehicles’ strong resale values to support the sales of their new ones. High resale values gain consumer trust, and it also keeps monthly lease payments low (leasing was 30% of the new car market pre-COVID-19). Dealers are required to buy used vehicles at the residual values automakers set in their lease contracts. This allows automakers to control future resale values on cars leased today by knowing their dealers will buy them at a pre-determined price at lease end.
This guarantee allows automakers to be competitive with their monthly lease payments; the lower the payment, the more likely they can steal new car market share away from competing automakers. If automakers lose their dealer footprint, they’ll be responsible for inventorying, reconditioning, and selling used vehicles – and all the liability risk associated with used vehicle resale values.
An example of the challenges resulting from bypassing dealers to sell used vehicles is found with TESLA. Compared with other luxury automakers, TESLA has low lease penetration, resulting in less used cars to sell because it does not have as many coming off lease. Even still, the company struggles with reconditioning used vehicles and drew criticism for selling pre-owned cars with major defects. Despite nearly half of luxury car buyers preferring leasing, TESLA avoids aggressive lease programs because its high demand means most buyers have no choice but to purchase. But once TESLA has formidable competition from future EV model releases, both TESLA and the incumbent automakers will fight for low monthly lease payments as a means to steal market share. Thus, dealers reconditioning, selling, and accepting risk for used vehicles is critical for the incumbent automakers. Recognizing this reality, many Wall Street investors suggested that automakers should sell their off-lease vehicles directly to companies like CARVANA as a means to bypass dealers and still sell high volumes of used vehicles.
While CARVANA made strides in online sales, it also proved that the online-only selling model is not perfect. The retailer hasn’t demonstrated cost savings from its online business model for consumers, nor has it demonstrated any cost efficiencies in its business model for investors. A recent WSJ article questioned the company’s cozy relationship with large physical auto retailer DriveTime, which provides many “physical services” to CARVANA so the company can “sell online.” Moreover, CARVANA recently announced its acquisition of ADESA auctions in order to gain “physical assets” for its online-only model. Without any clear cost benefits to the online-only model, most used-car buyers prefer a combination of online and offline options to make a used-vehicle purchase.
Caption: A review of used pricing between Carvana, Vroom, CarMax, and local franchise dealers shows no evidence of lower prices from the national brands. This example indicates that the local dealer sells a manufacturer certified vehicle for a comparable price with the added benefit of the manufacturer’s certified warranty. Pre-COVID-19 data was used as supply constraints are causing irrationality in the pricing of the current used car market. Data from the Atlanta market.
But won’t direct selling increase automakers profits – and therefore valuations and access to cash?
Dealerships operate at an average net profit of 2% of sales. Prior to COVID-19, the majority of profit came from automaker incentive income, service, and used cars. For most dealers, selling new cars was unprofitable and resulted in massive losses. It’s unlikely that automakers can generate favorable returns by eliminating dealers, especially given the tremendous cash outlays they’ll first need to make. These cash outlays will worsen their stock market valuations, which are already plagued by the transformation to electric vehicles. Until Wall Street values the incumbent automakers like it does TESLA, financial realities make selling direct to consumers unlikely.
Remember Saturn? The now-defunct automaker was marketed as a “new kind of car company” and featured no-haggle pricing. Many Saturn owners chose the brand due to its simplified retail model.
While TESLA and CARVANA demonstrated that the online-only model is not perfect, they proved that most consumers prefer a streamlined and no-haggle sales experience. With many consumers demanding this approach to car buying, including millennials who are now the largest new car buying segment, automakers will undoubtedly simplify elements of their new car sales process to make it haggle-free. But financial constraints and dealers functioning as “cash bag holders” suggest that automakers are unlikely to force change on the dealer model anytime soon.