Last year, Mike Jackson, chairman and CEO of AutoNation, commented that our industry’s operating benchmarks have not changed in half a century.  He was speaking specifically about our inventory supply and the long held belief that a 60-days supply of new vehicles is the right level.  He went on to note that a 30-days supply may be a better target, particularly given our uncertain economic growth.   At a 30-days supply, auto manufacturing would come closer to a “just-in-time” model, driven by market demand, rather than production capacity, an approach taken by most profitable manufacturers.

His comments were timely, as that is exactly where the industry headed last year.  From February to August, days-supply of new vehicles dropped a staggering 75%, from 118 days to 30 days.  Of course, flooring expense followed.

The average dealership flooring interest declined by more than 50% between November 2008 and November 2009.  (The federal funds rate has been at 0%-.25% since November 2008, so interest rates did not contribute to the decline in flooring expense, if anything flooring spreads have widened since then).     

How did inventory levels drop so dramatically?  Manufacturers got religion.  In the eye of the credit storm, they recognized that loses could not be overcome by sales volume.  The production push had to end.  In an era of economic uncertainty, dealers also faced the challenges of forecasting sales volumes and the risks of too much inventory.  As a result, a 60-day supply of new vehicles quickly became the old normal benchmark, indicative of a time of greater economic clarity.  A 30-day supply may be the new normal benchmark.

Unfortunately, after many months of decline, new vehicle days supply has resumed its upward climb (see Chart 2).  Dealership lots again are filling up with aged inventory and production capacity remains far above market demand.  Contrary to the manufacturers’ rhetoric, we may be headed back to the old push production model.  This would not only be a travesty for manufacturers, but very disappointing for dealers.

 Chart

Source:  NADA

Days Supply of New Inventory

Why are inventory turns so important for retailers?  Because retailers that manage their days supply of inventory at low levels usually are more profitable and often have stronger cash flow.  Let’s consider the largest retailer in the world, Walmart, and see how it manages its inventories.

Walmart maintains about a 40-days supply of inventory, an amazingly low level considering how many products it sells and the importance of product availability to its business model.  Walmart usually sells its inventory way before it is required to pay its suppliers.  As a result, the suppliers in effect provide Walmart with very attractive inventory financing.

Walmart figured out quickly the power of supplier financing – the faster it sells its inventory, the more capital it frees up for its business (if Walmart sells its inventory in 40 days but does not have to pay off its suppliers for 60 days, it has 20 days to use this cash to support its business).  As a result, Walmart has a shocking negative working capital account of $7.2 billion and maintains a .87 current ratio (current assets/current liabilities).  The retailer’s business model is predicated on this cash float provided by its suppliers.

Clearly, flooring lenders and auto manufacturers would never put up with negative working capital accounts, nor would they extend payoffs 20-plus days (if anything they are going the other direction).  But the Walmart example demonstrates the power of effective inventory management.  If dealers are funded on a car deal in advance of the flooring payoff, they have a few additional days to use that cash to support their business, just like Walmart.  Similarly, when a new vehicle sells quickly, a dealer that receives floorplan subsidies from the manufacturer, “makes money on flooring.”  Thus, by turning inventory quickly, dealers can increase their cash flow, just like Walmart.

Below are some additional perks of reducing days supply.

• Improved operations:  Organizations that turn their inventory quickly are usually more  efficient and profitable – actively managed inventory requires a high level of operational discipline.
• Less real estate:  In the long term, if the industry were to shift to less days supply, dealership real estate needs would decline, which would reduce fixed costs and improve profitability.
• Higher new vehicle prices and margins:  When supply meets demand, prices and gross margins optimize at a higher level – in contrast, when supply exceeds demand, prices and gross margins decline as a result of discounting, incentives, resale value diminution, and brand degradation.
• Less interest rate exposure:  We all know that interest rates have nowhere to go but up, since they cannot go down.  With less flooring and better inventory turns, dealers are less exposed to interest rate fluctuations.

In summary, we all hope our industry has learned the hard lessons associated with overproduction.  If you lose money on every car sale, you NEVER make it up on volume.  It is time for everyone in the car business to get squarely focused on the bottom line.  The most profitable manufacturers operate a “just-in-time” model.  Likewise, the most efficient dealers optimize their inventory for high turnover in order to increase profitability, streamline their systems and reduce their exposure to economic uncertainty.  Don’t let the manufacturer convince you otherwise – keep your new vehicle days supply at Walmart’s level.  If they can do it, so can you.