It only takes a few minutes of skimming headlines and articles covering the automotive industry to turn a smile upside down. Major manufacturing plants from automakers such as Ford (F 1.71%) and General Motors (GM 1.35%) have halted vehicle production, and analysts predict billions of dollars in losses as consumers avoid big-ticket purchases, such as vehicles, and social distancing keeps foot traffic far away from showrooms. Simply put: Business in the automotive industry is brutal during COVID-19.
But there's one factor investors may have overlooked that could also cripple major automakers: Plunging used-car prices. Sounds weird, right? Here's exactly how and why used car prices impact Ford and GM, and examples of how bad it could be.
Financial arms 101
If all you know about Ford and General Motors is that they primarily manufacture and sell vehicles, you aren't to be blamed. But one competitive advantage these automakers have had, for different lengths of time, is their financial arms: Ford Credit and General Motors Financial (GMF). These financial arms are a critical component for automakers as they assist consumers in financing their vehicles, leasing vehicles, as well as helping support dealerships. Better yet, these financial arms are hugely profitable for automakers most years. In the graph below, you can see that Ford Credit generated nearly half of Ford's pre-tax profit throughout 2019.
Outside of Ford's lucrative North America region, Ford Credit generates more pre-tax profit than its South America, Europe, China, Asia Pacific Operations, and Middle East and Africa, combined.
GMF performed in similar fashion: GMF generated $2.1 billion pre-tax earnings in 2019, which was more than its unprofitable international operations and a big chunk of its total $8.4 billion. That's how important Ford Credit and GMF are to their respective Detroit automakers. When business is strong and stable, financial arms are an incredible trick up automakers' sleeve for higher profits -- until the rare year a swift downturn can make them a detriment to the bottom line. So how in the world would plunging car prices impact their financial arms, and how drastic could the negative impact be?
When a consumer leases a vehicle from Ford Credit or GMF, the financial entity estimates a return value of the car expected upon lease end. During the majority of scenarios, this takes place with little adversity, and the financial arms generate a welcomed profit. However, when something drastic happens, such as COVID-19 disrupting business, which has sent car prices plunging, the returning vehicle values are significantly less than estimated, generating sometimes heavy losses for the financial arm. Automotive News reported that wholesale values are down between 10% and 12% as supplies of used and off-lease vehicles are stacking up, and there are less auctions and demand. How drastically could this impact Ford Credit and GMF, you ask? Let's take a look at the last time Ford Credit suffered losses when used-car prices plunged during the beginning of the financial crisis.
Ford Credit took a near $2.6 billion loss in 2008, and JPMorgan analyst, Ryan Brinkman, wrote in a report that if prices finish 10% lower during the second-quarter, total losses could reach $3 billion at GMF and $2.8 billion at Ford Credit.
What happens next?
Yes, this is a rough scenario for financial arms such as Ford Credit and GMF, but it's also bad news for rental fleets, such as Hertz and Avis, as well as used-car dealers like CarMax.
But there are levers that can be pulled to help offset some of the negative impact felt from plunging used-car prices. Notice in the graph showing Ford Credit's results: 2008 losses quickly spiked into a lucrative 2010 profit. Part of that was due to the cash-for-clunkers program, which helped significantly reduce the surplus of used cars and brought some balance to supply and residual values. Also, there are already reports of some automakers offering lease extensions to their customers. These measures essentially buy the financial arm time before it has to log the returning value of a car, which could mean better prices down the road.
COVID-19 and the drop in used-car prices will certainly deliver a speed bump to the automotive industry, but major automakers such as Ford and General Motors should have the liquidity and ability to offset enough of the negative impact to survive and focus on their long-term strategies. This is, however, a great reminder to investors that seemingly unrelated factors, such as used-car prices, could have a detrimental impact to a business that primarily sells new vehicles. It's a great example of why investors must keep learning, keep reading, and fully understand the businesses in their portfolio.