Embracing the opportunity in uncertainty - Navigating Economic uncertainties

Australia has enjoyed a robust economic performance despite the commodity price and mining investment bust¹. While the resilience of the Australian economy is commendable, with the global uncertainty since the GFC, Australian businesses have been increasingly confronted by the “new mediocre” globally for a better part of the decade².

A hard landing in China is cited as a major external risk, which may put the Australian economy under tremendous pressure.

The recent low interest rates have created a risk in terms of household debt. While the lower interest rates were useful in selling more cars, increasing amount of household debt casts a risk on future vehicle sales.

In this paper we will explore two of the three plausible scenarios put forward by Deloitte Access Economics in their recent study “What’s over the Horizon? Recognising opportunity in uncertainty”² and their possible impact on the vehicle retail industry in Australia.

1. Correction in the Australian Economy
2. Growth in the Australian Economy

In addition we’ll also explore the scenario where Asia grows but China slows down. These are plausible scenarios and not certain events. This paper models the possible effect of these economic scenarios on the Australian motor retail industry.

Correction in the Australian Economy: 

While the Australian economy has been strong and recession proof for more than 25 years, it’s fuelled its growth with exports from mining sectors. Nearly 50% of Australia’s exports are Primary products – Unprocessed Minerals and Fuels, and nearly 30% of the total exports are to China³. This raises the risk of too much exposure to one geography and one product or type of products. Recently we’ve seen the merchandise exports to China go down from $92 billion in FY 2014 to $75 billion in FY 2016³. This has seen the economies and the vehicle sales of states like Western Australia and Queensland come under pressure.

While the vehicle sales in states that are not heavily reliant on merchandise exports to china are seen to go up as seen in Figure1.1 when we take a closer look at mineral exporting states like QLD, WA & NT a different picture emerges as seen below in figure 1.2

 

According to Deloitte Access Economics, if China was to tip Australia into a recession, the Australian GDP would shrink by almost $140 Billion, cutting around 500K jobs, and would push the house prices down by at least 9%. A reduction of this scale would put private and business buyers of automotive products into a holding mode.

The passenger segment has seen almost a 9% contraction this year, which was compensated by the SUV segment. However, business buyers made up a significant portion of the SUV segment to the tune of 15% till May this year. So anything that impacts businesses may impact SUV sales, and that may impact the growth of total industry sales. A correction in Australian economy would also put pressure on the Australian Dollar and it may lose at least 15 cents making imports costlier. Debt may become more costly as while the Australian Federal bank may cut interest rates, banks don’t borrow from the Australian reserve bank they do it from the world markets and the global markets may not lend to a country in recession at cheap price². This increase in import prices coupled with increase in interest rates and inflation could put pressure on the sale of vehicles, particularly luxury variants.

The impact would not be uniform across all states. States with larger and direct exposure to sales to China may feel the impact more than others as seen from historic data in Figure 1.2 earlier. While we can’t predict the quantum of shrinkage for new vehicle sales, our research shows that in worst case scenarios a dollar lost in new vehicle sales erodes the new vehicle selling gross by up to 23 cents. Our research also further shows that if a dealership makes a loss in the new vehicle department, there is at least a 50% chance that it’ll make an overall loss, as all the other departments are directly or indirectly dependent on the new vehicle department.

For this article we ran multiple scenarios of new vehicle sales erosion and simulated the effect of that loss on the Australian dealer landscape. While nobody can accurately predict the actual erosion of sales, we will illustrate the possible effects of a 10% loss in new vehicle volume and a 30% loss in new vehicle volume in an effort to explain the cascading effects that loss may have.

 

 

As we can see from the figure above, the states which are front end driven would feel the impact of the new vehicle sales slowdown more as compared to the states which are more balanced.

Let’s look at what effect a loss in new vehicle sales may have on the total dealership operations and profits. Simplistically a 10% erosion in new vehicle sales may erode the F&I income by up to 23% and the overall profitability by up to 25%. This effect cascades exponentially at a 30% loss in new vehicle sales as almost over 60% of all dealerships across Australia may turn loss making. This loss of new vehicle sales may put additional pressure on dealers whose cash cycles are aligned to the franchise bonuses, and could have an impact on their cash flows. To prepare for such a change in the business model, businesses need to start assessing the health of their business as early as possible.

The Australian dealerships should:

Identify potential risks in their cash flow cycles –

1. Dealerships need to assess their stock situation with respect to New and Used vehicles,
2. Identify potential large debtors in the parts department, and
3. Assess their reliance on quarterly bonuses

Optimise their business processes –

1. Focus on improving the parts and service absorption to better bolster against fluctuations in vehicle sales
2. Bolster the parts and service department to make the dealership more balanced
3. Improve productivity across all departments
4. Embrace principles of lean management in departments to keep headcount optimum

Develop a self-sustaining business model –

1. Identify avenues by which major fixed costs can be funded perpetually
2. Assess ways by which business risks can be diversified e.g. Geographic spread, heterogeneous client base
3. Identify possible exit scenarios

Growth in the Australian Economy: 

Let’s now look at a more positive scenario where the Australian economy continues its winning streak and grows even further. Why would this growth happen? Asia is soon emerging as the powerhouse of this world, economically and demographically. Asian countries of India, Indonesia and China make up more than half of the global population. The demography in this geography is suitable for immense growth and Australia enjoys close proximity to this geography. Along with close proximity to this geography Australia is also in a position to export resources to these countries and attract highly qualified professionals from these countries.

With a conscious effort the Australian Economy has started decoupling itself from mining and started growing into IT and other human talent intensive sectors. This advantageous position of being able to export resources and attract skilled professionals may give the Australian economy a boost as Asia grows. All these factors make a growth in the Australian economy a very plausible possibility with sectors like mining, construction, Infrastructure and IT services growing. Like we saw in the case of an economic correction, the effect of this growth will not be uniform across Australia.

The same can be said of the sectors that are within the Australian economy. With a growth spurt sectors like Finance and Insurance should be one of the biggest winners followed by mining, agriculture, transport, sectors like manufacturing may not benefit much from this growth.

Thus we can say that a gain in the Australian economy, while favouring the entire country, could be more gainful for New South Wales, Victoria, Queensland, and Western Australia as compared to Tasmania, South Australia and Northern Territory.

The motor industry will have to prepare itself for a growth spurt. As with an increasing population and more disposable income, the population may want to buy more vehicles and maintain the existing ones. If there is an increase in the population and business, the additional demand for residential and business space may be arising in outskirts of big cities, and in tier 2 towns. This may mean that the regions that benefit the most maybe provincial and rural regions.

Dealers in Australia need to take this possibility into account while planning for their future business growth. Large dealerships need to have a balance in their presence in the cities as well as regional towns. For Australian dealerships to be able to take advantage of the growth scenario in the Australian economy they’ll need to:

1. Have positive cash flows in current scenario, this positive cash flow can fuel expansion
2. Diversify their brand and geographical foot print – be aware of shifting demographic footprint
3. Have an adequate pipeline of talent and succession planning – Motor dealerships will have to compete with other sectors to attract and retain talent
4. Have an effective marketing program, and focus on online marketing program as this is highly agile and can be tracked effectively
5. Look for synergies with another group as collaboration maybe a better growth option

 

Growth in Asia but a Slowdown in China: 

Let’s now look at the possibility where two seemingly exclusive events might happen together. Asia continues to grow, but Chinese economy starts slowing down as it becomes more mature.
This scenario may put pressure on Australia’s primary production as exports to China will be hit, simultaneously boosting non-primary activity. This may mean that Australia exports less of minerals and energy but has increased economic activity as a result of IT and Infrastructure boost and increased levels of skilled migration.

These two scenarios playing out together will impact different states in a very different fashion. As we’ve seen from the examples above, states more engaged in primary production (Mining and Fuel export) could see a reduction in economic activity and states who are more biased towards Finance and Insurance, Agriculture, IT and Infrastructure may see an increase in economic activity.
These structural changes in the economy may see a reduction in new vehicle sales in states like Western Australia and Queensland while seeing an increased offtake in states like New South Wales, Victoria, and ACT. States like South Australia, Northern Territory and Tasmania may see an improvement in new vehicle sales, but to a lesser extent.

While these scenarios seem very different from each other, the common thread in all is that, dealerships that are agile and can adjust rapidly will survive and flourish while dealerships that cannot adjust rapidly may diminish. While nobody truly can predict the future, it’s always best to be prepared. Best business practices help businesses remain agile so that they can shift gears as needed be it a boom or a bust scenario.

Common best practices that may help your dealership and your dealer network are:

1. Assess the health of your dealership / network for stock build up
2. Identify potential risks in your business like – dependency on bonuses, precarious cash flow cycles, inefficiencies in departments
3. Identify over reliance on a particular type of clientele, product, process
4. Plan against an inefficient geographic footprint
5. Identify possible partners with synergies that can be leveraged
6. Grow and groom talent for the future

If you wish to better understand these uncertainties with respect to your business and understand how you can gain more from our benchmarking, future modelling and analytical capabilities we would be pleased to discuss the results of our analysis with you.

Authors:
Balram Dabhade and Dorian Lapthorne

 

References:

1 2016 article IV consultation—IMF Country report no. 14/42

2 What’s over the horizon? Recognising opportunity in uncertainty – Deloitte Access Economics

3 Department of Foreign Affairs and Trade – Australia – Composition of Trade

 

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