A Return of Margin Compression? Yes, But Not Necessarily

I’ve been struck by how often the term “margin compression” has come up in recent conversations with dealers.

Interestingly, dealers aren’t necessarily complaining about margin compression. It’s more accurate to say they’re starting to notice it in their used vehicle operations. Just this week, for example, two different dealers shared a surprisingly similar story: A few short months ago, their front-end gross profit average was about $3,200. Today, it’s about $2,800, and both expect it to continue to contract.

I suspect dealers aren’t complaining about margin compression because the market dynamics we’re seeing right now don’t necessarily correlate to the margin compression many dealers faced prior to the COVID-19 pandemic. Back then, dealers were selling record volumes of used vehicles, and making $14 in net profit per used vehicle retailed, according to NADA. Most dealers were happy if their front-end gross profit average landed between $1,300 and $1,500/vehicle.

The current moment might best be described as an essentially definitive end to the margin-rich environment dealers enjoyed the past two years. Retail prices are starting to come down from their historic highs, almost in line with current rates of used vehicle depreciation. Further, analysts expect the trends to continue, with some suggesting retail price and wholesale value declines might fall steeply compared to historic norms.

But I must also add that the effect of margin compression, and its material impact on used vehicle performance and profitability, isn’t like the margin compression dealers dealt with in previous years. I’d submit the current flavor has two important distinctions.

The first distinction is that market forces that drive margin compression no longer affect all used vehicles equally. Think back to this past summer, when depreciation resumed in earnest. While the overall rate of depreciation was high, some cars were hit harder than others. The differences owed to the supply/demand characteristics of different vehicle segments, model years and other factors. We still have supply/demand imbalances in the used vehicle market and where those imbalances occur, the effects of margin compression will vary.

The second distinction is that margin compression isn’t affecting every dealer equally. Based on my conversations with dealers and reviews of their used vehicle performance, dealers with a lot of older, now-distressed vehicles face a steeper degree of margin compression than dealers who have diligently right-sized their inventories to retail demand and remain focused on turning each vehicle in a time appropriate to its investment value. Some of the more market-efficient dealers report they haven’t seen much softening of their front-end gross profit averages at all—an advantage that speaks to the benefit of operating with the current market always in mind.

As I talk with dealers about margin compression, I’ll make another important point: If you attack the operational reasons your margins may be on the decline today, you’ll have less to complain or worry about if/when the pace of margin compression picks up.

dalepollak.com

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