“Cash For Clunkers” Part 2: Used Car Dealers

Used car prices skyrocketed in 2021 due to supply chain disruptions for new vehicles and inflationary pressures across the globe. The classic supply-demand effects were seen in every region of the United States as the population moving from cities to suburbs needed more effective transportation. The increased car demand pushed up the prices for a smaller supply of vehicles as new cars were not able to be delivered to the market. As vehicle prices soared, car owners saw the cash they could receive for their assets and started to sell.

Automobiles are a notoriously poor investment as the asset depreciates every year. The depreciation stems from several factors including a new model of car being released in the market annually, and the technology on the vehicle becoming outdated. Additionally, cars have a limited useful life, and the closer a car gets to the end of this life, the less efficient and valuable the car becomes. Car dealers know these assets depreciate quickly, so car dealers arrange financing to purchase vehicles for their inventory and then deploy a team of sales representatives to sell these cars as quickly as possible to turn a profit. This depreciating asset (car) then gets passed to the consumer who takes out financing to purchase the depreciating asset. The consumer is the one who ends up holding the bag and financially losing on the deal long-term. Used car dealers work very hard to not be left holding the quickly depreciating asset because an out of date inventory is worth less and is harder to sell. This is an important point for later.

The Used Car Boom

The pandemic caused a mass exodus of people out of coastal cities where car ownership is not the norm, to regions of the country where having a car is the best way to travel. This national trend layered on top of global supply chain disruptions caused buyers to flood the used car market. The surge in car buyers caused used car prices to rapidly rise. Since used car inventories were built efficiently for normal buying times, the inventories of used car dealers became depleted practically overnight. This inventory depletion led car dealers to pay top dollar for used cars in an effort to incentivize car owners to sell their vehicles quickly for the dealers to meet the increased car demand. Car owners were consistently getting paid more in 2022 to sell their car than they originally paid for their car several years ago. As the word got out about these appealing cash offers for used cars, more and more people came to dealers with their vehicles to fetch extra cash. I was one of the sellers in early 2022. When I came to sell my SUV at a premium to the market value a year prior, I was shocked at how slow the showrooms were. The sales representative told me mostly sellers were coming in now to offload their vehicles. This was over 6 months ago and a lot has changed in 6 months.

As 2022 rolled on, interest rates began to rise causing the average monthly car payment to significantly increase for the marginal car purchaser. Increases in car prices and increases in interest rates cause significant pressure on the consumer’s discretionary income. That pressure is beginning to materialize today. At the time of this writing (late 2022), auto loan defaults have risen causing vehicle repossession rates to tick up. The difference between past car repossessions versus car repossessions today is most vehicles now have a GPS tracking system installed. This tracking system allows the lender to locate where the car is and execute a repossession within the week instead of waiting for months in the past to locate the asset. The lender moves quickly on repossessions now because the used car market is still hot so they can flip the car over and sell it without much friction. This is an added supply of cars each month coming back to the market as lenders want their cash back as quickly as possible.

Leading us to the main issue: used cars are depreciating assets in which prices have increased temporarily (even though temporary can look like multiple years) due to an increased demand. This price increase has led to more sellers than buyers of cars as the dealers filled their inventory with whatever car they could get their hands on over the last 12 months. The economy is now slowing, and interest rates are rising, which decreases the appetite for consumers to buy on credit. Supply chains for new vehicles will start coming back online allowing for new cars to be sold to consumers. Used car dealers will begin to see even less buyers and now they have 12 months of inventory they paid above market value for that needs to be written down and further depreciated as time goes on. Not to mention the debt these companies took on to finance the above market value purchases. This leads to a spiral of lower used car prices and more inventories write downs, dealer defaults, layoffs, and less consumers in the economy. And this process has already begun:

Chart 1: Used Car Price Index From 2006-2022 (Source: TradingView)

As Chart 1 shows above, used car prices are starting to decrease. This will lead to inventory write downs for car dealers.

Inventory Write Downs Coming Fast:

Looking at a major public company operating in the used car industry, you can see the potential implications of the pending inventory write downs across the industry.  CarMax has a market capitalization of $11 billion. As of their most recent quarterly financial filing with the SEC, CarMax had an inventory valued at $4.6 billion, or roughly 40% of the market value of the company. This is up from the $3.1 billion in inventory just a year and half earlier as seen in Tables 1 and 2 below. Further confirmation that used car dealers loaded up on inventory over the last 12 months.

Table 1: Inventory Levels For CarMax (Source: SEC Financial Statements Reported By CarMax in 2021)

Table 2: Inventory Levels For CarMax (Source: SEC Financial Statements Reported By CarMax in 2022)

If we assume used car prices will fall by a conservative 30% in the next year, this will equate to a roughly 30% write down in inventory for used car dealers. For the example of CarMax, a 30% write down using August 2022’s inventory level equals $1.3 billion or 12% of the market value of the company. And this does not even include losses on auto loans coming down the pipeline.

Past Due Auto Loans:

Individuals who purchased cars in the last year are going to realize their asset is upside down financially as used car prices contract. If the owner of the car is sitting on a quickly depreciating asset and paying 7-8% interest on the loan, the owner will be more incentivized to default on the loan. As these defaults become more prevalent, financiers of the car loans will be in even worse shape as their inventories of used cars will continue to build causing more write downs and losses. Looking at CarMax again, the loans marked as “Past Due” have increased by roughly $400 million or 4% of their market value in the last 6 months. This is only the beginning too. If these past due loans continue to rapidly rise, used car dealers will see a downside catalyst not seen since 2008.

Table 3: Past Due Auto Loans For CarMax (Source: SEC Financial Statements Reported By CarMax in 2021)

Table 4: Past Due Auto Loans For CarMax (Source: SEC Financial Statements Reported By CarMax in 2022)

We are only looking at a large scale example of the used car industry. There are many smaller, private used car dealers that are in tougher financial positions due to lack of available financing at their individual level. These private companies also do not have to report results as frequently to investors, so it is very likely the inventory build up has not even raised a red flag yet.

Imagine if supply chains opened up, unemployment rose to 6%, and the economy came to halt with tight financial conditions finally showing their teeth in the next quarter or two. This may even be your base case by mid-2023. Who is going to be buying used cars at these elevated price levels after their technology is out of date by 3+ years and new cars are cheaper? What used car dealer is financially prepared for this? I would bet none of them. And that leaves all of these used car dealers holding the bag of rapidly depreciating assets on margin with no buyers.

The stock market is a forward looking indicator. With Carvana’s stock price dropping from a high near $400 per share in 2021 to $10 per share in 2022, I believe the market is seeing the picture of the deep issues the used car industry is facing long-term. The question is, are we?

Chart 2: Carvana’ Stock Price 2021-2022 (Source: Koyfin)

Don’t fight convexity.

Disclosures: (Personally Waiting For A Vehicle Fire Sale)

This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into used cars and used car dealers. Though compelling, your own research should always be done before investing into any security. The risks mentioned in this post are not all encompassing either. This post should not be viewed as investment advice. Tetelestai Capital is not associated with any of the investment companies or products mentioned in this post. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.