Just last week we signalled the challenges arising for US auto retailing. Like a used car salesman appearing at your side as you inspect that midnight blue Ford, news arrives to confirm our view. CarMax Inc, the largest U.S. used-car retailer, fell 8.5% after reporting a lower-than-expected quarterly profit as growth in comparable unit sales at its used-car lots slowed to a near halt, hurt by tighter lending norms that kept subprime customers at bay. Growth in comparable-store unit sales at its used car lots nearly ground to a halt, rising just 0.2%, down from 15.9% growth a year earlier.
Our view is that in a relatively fixed market for cars, the market for substitution of existing cars (where a desire for a new car meets cheap credit ) eventually is met. We note in the chart below that US auto sales are nearing the levels seen prior to the global financial crisis.
This substitution effect contributed significantly to KMX’s 2Q miss, with consumers continuing to trade up from used vehicles to new. At the moment this trend is exacerbated by late-model used vehicle pricing remaining at near all time highs and new vehicle financing rates at record lows, leading to a relatively small differential in vehicle financing costs. Rationally, until a new car costs a lot more than a used car, that trade off is likely to continue. But not forever.
Our view is that we are reaching a tipping point, with pent up demand for new vehicles likely to be reached in the near term. Certainly, US light vehicle inventory has been turning over rapidly (US light vehicle days supply dropped from 95 in January to around 54 in August – this is driven in part by the arrival of new models in October, and in any case, if sales are back at pre-recession levels, then demand is likely to soften through to the end of the year. Forecourts will fill with used cars, and the only way to clear them is by keeping prices down.
This is not mere theory – consider Chart 2 below, evidencing that volumes are being supported by weak pricing power. It shouldn’t take much tyre kicking to work out the implications for margins.
The Euphoric Loop