Auto dealers have turned consumers into junkies over the past two years, offering bigger and more enticing incentives to boost sales. They're now realizing how hard it is to kick the habit.
Even though the economy has shown signs of life recently, consumers still seem unwilling to open up their wallets unless they think they're getting a bargain. A recent study by Kelley Blue Book and Harris Interactive found that 66% of those who plan to buy a car in the next 12 months said available incentives will greatly affect the timing of when they buy that car.
"Manufacturers thought this was a temporary fix to get people interested in their product," said Mark Brueggemann, editor at Kelley Blue Book. "But once you give something to someone, they come to expect it."
Generous incentives such as big cash rebates and 0% financing were first introduced by automakers after Sept. 11, 2001, in an attempt to lure customers back into showrooms. Today, aggressive incentives have become a permanent fixture, and profitability continues to suffer as a result.
"It wasn't long ago when 0% financing was considered the ace up the sleeve that they pulled out only in very dire circumstances," said Kevin Tynan, an analyst at Argus Research. "The auto dealers say the incentives are addictive, they're like a drug."
As the economy began to surge higher in the third quarter, the Big Three auto firms tried to ratchet back incentives on some of their 2004 models. The result was not good. Although there were several factors behind the slowing pace of sales in October, lower incentives were a significant reason.
are all hopeful that as the economy turns around, sales will pick up. But it will take months before the unemployment rate starts to fall, and consumers are already heavily indebted. Although the cost of servicing debt is low, the amount of debt relative to the size of consumer balance sheets has never been higher, according to David Rosenberg, chief economist at Merrill Lynch. The economy, he said, has become "addicted to leverage."
McDonald Investment analyst Brett Hoselton said incentives may be here to stay because of structural changes in the auto industry, including greater capacity from both domestic and foreign manufacturers. "We do not expect pricing pressure due to 'oversupply' to abate anytime soon," he said.
Most analysts expect incentives to rise through the end of the year, and while price increases on vehicles will help to offset that to some extent, the net effect will be negative for earnings.
"We would expect incentives to start moving higher in November," said Credit Suisse First Boston analyst Christopher Ceraso. "Most notably, we would look for Ford to begin putting some cash on the hood of its new F-150 model."
Ford conceded that sales of the truck were held down in October by the stingy level of incentives. "I think it turned out to be a lot bigger issue than they originally thought," said Brueggemann. "It's going to be interesting to see if they'll play together to wean everyone off."
Tynan doesn't think that's likely. He said dealers will only scale back incentives when the
raises interest rates. Until then, the trend will continue, and that's particularly bad news for Ford, which has been hurt more than most by the price wars.
"If everyone agreed to stop, they'd all be in the same boat, but GM is the one that won't stop," Tynan said. "It's really trying to go for the throat and keep the pressure on."
While General Motors' financial standing isn't great, it's certainly better than Ford's, and the company has been using this advantage to cripple its competitor.
So far, it's been working. Earnings at Ford have been poor this year and are expected to improve only marginally going forward. In addition, weak cash flow has hurt research and development, and the company's portfolio of products is generally unimpressive.
One of the most immediate concerns for Ford is a potential debt downgrade by Standard & Poor's on Nov. 18. Last month, analyst Scott Sprinzen placed Ford's bonds on credit watch, saying that the firm had become too reliant on cost-cutting to boost profits and that it is seeing continued losses in Europe.
While Ford is "awash in cash," it also carries a lot of debt, he said, with underfunded pension liabilities of $25.4 billion and retiree medical liabilities of $30.3 billion. Even if pricing recovers and demand picks up, Sprinzen believes a big pickup in earnings is unlikely.
To be sure, an improvement in the economy and stabilization in unemployment would help Ford, but the company has given up a lot of ground in recent years and has seen its market share drop to just 22% from 27% in 1998. "It is quite obvious that if the share-loss trend continues at its present pace, Ford would cease to exist in about two decades," Hoselton said.
Ford must match incentives offered by General Motors and Chrysler or sell fewer vehicles and risk losing market share, noted Hoselton. And while the company has enough cash in the bank to do this, this is clearly going to hurt.