Ford Motor Company's (NYSE:F) financial arm, Ford Credit, has been a massive advantage in recent years. Glancing at the third quarter will emphasize just how profitable the entity is. While Ford's North American automotive segment generated $1.26 billion in pre-tax profits, the next closest segment was Ford Credit, which generated $552 million. That result was far ahead of the next closest segments, its automotive businesses in Europe, which generated $138 million, and Asia Pacific, which generated $131 million.
However, one rare downside of owning a financial division is that a drop in residual values can cause some bottom-line pain. That's a trend investors should be watching in 2017, because we're already seeing some warning signs.
Last year 3.36 million leased cars, trucks, and SUVs were returned after a set length of time expired, a 33% jump compared to 2015. While that may not seem like an issue, it's a much bigger deal than many investors realize. As the market is flooded with these vehicles, residual prices sink lower. When residual prices plunge, entities like Ford Credit are on the hook if prices don't cover what they had previously estimated the car to be worth upon its return. And prices are indeed beginning to move lower.
The National Automobile Dealers Association's Used Car Guide's price index moved 4% lower in 2016, compared to the prior year, which was the first significant decrease since the past recession. As you can see in the graphic above, which covers part of 2016, the index moved lower each month during the back half of the year. Furthermore, the average used car depreciated by roughly 23% in 2016, faster than the typical rate of about 18%.
The impact was swift and felt over a wide range of businesses, from weaker used-car prices at CarMax to profit reduction at Hertz Global Holdings and, of course, Ford Credit, which lowered its finance arm's pre-tax estimate by $300 million for its full-year result.
Even more worrisome is that this trend appears here to stay, as the number of off-lease vehicles continues to rise. "We expect this trend of above average annual depreciation to continue in 2017 and 2018," Edwin Groshans, an analyst at Height Securities, wrote in a report, according to Bloomberg. This may may put a strain on other companies that finance auto loans, he said.
What can be done?
Over the long term, Ford has a couple of levers it can pull to help offset weaker residual values. One involves simply assuming weaker residual values upon the lease signing, to give more margin of error. Ford could also reduce the number of leases it's willing to dish out, which it already has done: Ford Credit leased only 18% of its retail sales during the most recent quarter, compared to 26% during the first quarter. Ford could also attempt to boost values by expanding its certified pre-owned vehicle program, basically offering used cars with extended and more valuable warranties.
This leasing bubble, if you want to call it that, is a little more worrisome than previous examples. That's because in the past leases were mostly used for high-dollar luxury vehicles, and thus it was a problem mainstream automakers largely avoided. This time, though, leasing has become more of a mainstream option for SUVs and trucks, which makes it a more widespread issue for automakers and their investors.
Automakers' bottom lines reaped the rewards as consumers were readily buying higher-priced vehicles and using lease options to do so, but now the end of that scenario could come back to haunt carmakers. Investors would be wise to keep an eye on used-vehicle prices and tune into Ford Credit's fourth-quarter report this Thursday for more insight.