Why Does GM Care About Used Car Prices?

Last year, Volkswagen (NASDAQOTH: VLKAY  ) was the most profitable automaker in the world, reporting a huge $15 billion in operating profit.

That blew away the totals from Toyota (NYSE: TM  ) and General Motors (NYSE: GM  ) , the two automakers that sold more cars than VW.

But while Toyota's $11.1 billion operating profit was at least in VW's ballpark, GM's $7.9 billion total wasn't close.

GM CEO Dan Akerson is doing everything he can to close that gap – including something that might not seem to make any sense at first glance: trying to raise the used prices of GM cars and trucks.

GM's used car prices: improving, but not yet great
What GM actually cares about is "residual values", the term for how much a vehicle is worth at the end of a lease. If you lease a new car for three years, and the car is worth $20,000 at the end of the lease, that's the residual value. But it's often expressed as a percentage: If your car's sticker price when new was $50,000, we would say that its residual value was 40%.

For a long time, GM's cars had terrible resale values, a legacy of the automaker's reputation for cheapness and unreliability. As recently as 2009, in the wake of GM's high-speed bankruptcy reorganization, GM's overall residual values were just 36.5%.

That number has already come a long way, thanks to the improved quality of GM's cars and trucks. According to a recent Bloomberg report, GM's average residual value in 2012 was a respectable 44%.

Respectable, but not great. That's still below the industry average of 46.5%, and well behind the 51.5% posted by Honda (NYSE: HMC  ) , the leader among mass-market brands.

But why does GM care about the prices of its used cars?

Why GM cares about its used car prices
As Chuck Stevens, CFO of GM's North America division, told analysts last week, GM cares because those lower residual values cost the company more money when it comes to leasing. Automakers like GM set lease terms based in part on what the car is likely to be worth at the end of the lease.

If its residual values are higher, that makes it easier for GM to offer lower, more attractive lease terms on new cars. Stevens said last week that GM spends between $150 million and $200 million a year to make its lease offers more competitive with rivals whose cars have higher residual values.

Put another way, GM can raise its residual values, it could save up to $200 million a year just on its leasing business – never mind the added potential benefits, like more sales and increased customer loyalty.

So how will GM raise those values?
What GM needs to do is what Ford (NYSE: F  ) , whose residual values were a little ahead of GM's last year, has been working hard to do: Make better cars and trucks that can command premium prices with lower sales incentives. That's the formula for improving resale values, in a nutshell.

GM's cars and trucks are getting better. It's the pricing that will require discipline, as Ford has discovered. Even though Ford – which is ahead of GM on the product improvement front – is building some seriously nice vehicles, and has mostly achieved parity with the industry's best on the quality front, its incentives are still higher than those paid out by rivals like Toyota.

Ford has already reduced its incentives considerably over the last few years, and most expect the company to continue to ratchet them down over time. For GM to make gains on residual values, it'll have to stay focused on following suit.

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