Retailers put the brakes on starting captives

Dazzled by the profits CarMax earns from its lending unit, other big automotive retailers have explored starting their own captive finance companies. But the undertaking is challenging and expensive, and that has caused some prominent dealership groups such as AutoNation to pull back on the prospect.

Others continue to look into captives but with more caution than expressed previously. Executives for Sonic Automotive, for instance, said this year the dealership group is slowing its plans to establish a captive finance arm. That was a change from October 2014, when company leaders said they would build a captive, with a start date four years away.

Bottom line, establishing a captive is expensive and can be a big risk for a dealership group, said Mike Buckingham, senior director of the auto finance practice at J.D. Power. Although it may make sense for some retailers, they have to have considerable size and scale to pull it off.

"Where people have had fits and starts, it's probably putting pencil and paper to it and realizing what it's going to cost and balancing that with what's the potential risk," Buckingham said. "The other thing is there's a very heightened regulatory environment there, so that's a new layer that anyone, whether auto dealers or just a startup, is going to have to contend with."

Indeed, Jeff Dyke, Sonic's executive vice president of operations, cites regulatory concerns as a reason for the retailer's slowdown.

"There are so many government regulations and rules, it makes it almost impossible to do it," Dyke said. Sonic is considering a captive down the road as a way to support EchoPark, its stand-alone used-vehicle unit, he said, but "we're not ready yet."

Sonic sold its previous finance arm, Cornerstone Acceptance Corp., in 2007. In past interviews, Scott Smith, Sonic's co-founder, indicated the business model of any future captive would differ from that of Cornerstone Acceptance, which he described as offering "sub-subprime" credit.

AutoNation Inc. made a more final decision this year to end its exploration of a captive. CEO Mike Jackson said in November 2014 the retailer was in active negotiations on the prospect. But by April, Jackson was describing the project as "on the back burner with the gas turned off." In October he said the idea of a captive wasn't even on the stove anymore. "It's primarily a return-on-capital issue and the cost of capital and competition issue and a scale issue," Jackson said. "Moving into originating loans that we hold or package, and looking at the competitive set, there are other companies that do it extremely well on a cost basis that would be lower than what ours is and with whom we have great partnerships." 

AutoNation had a finance unit in the early days of the company, but Jackson pulled the plug on the money-losing operation in 2001. 

Other dealership groups have set up or explored captives. 

In October 2014, Larry Van Tuyl said his dealership group, which was then about to be acquired by Warren Buffett's Berkshire Hathaway, was studying the formation of a captive finance arm that would operate online. Leadership at the former Van Tuyl Group, now called Berkshire Hathaway Automotive, did not respond to inquiries seeking an update. 

In a pilot project, Lithia Motors Inc. set up a captive a few years ago called Southern Cascades Finance Corp. It's small, with $15 million in contracts. It mostly operates in the subprime arena with loan-to-value ratios of 80 percent or less, Lithia CEO Bryan DeBoer said. "They are pretty risk-averse, and we believe that's an appropriate size for the organization today," he said. An impetus for starting the captive was the feeling there could be disconnects in lenders' views or excessive charges in administrative fees for stable loan candidates "who had hard times," he said. 

Asbury Automotive Group has considered forming a captive someday for its Q auto stand-alone used-vehicle stores. It has just three of those stores today, and it's too soon for a serious look at it right now, Asbury CEO Craig Monaghan said. But down the road, Asbury could explore it more. 

"If you were to take a look at the CarMax model, they generate a significant amount of their profitability from their captive," Monaghan said. "So it's logical to look at this business." 

Still, Monaghan noted the risk, saying other retailers have set up captives and lost "a tremendous amount of money." 

Retailer-owned captives are a tiny fraction of the auto finance market, Buckingham said. 

CarMax is the king, earning more than half of its profit from its captive. In its most recent quarter, CarMax reported income from its finance unit of $98.3 million. 

The Larry H. Miller Group of Cos. operates a large dealership network and a finance arm, Prestige Financial Services. It specializes in subprime lending and was founded to serve the Larry Miller stores exclusively but has since expanded far outside that footprint. 

"Those are really the only two that have stood the test of survival and have size and scale to them," Buckingham said. 

Establishing a national lender -- getting the infrastructure and personnel in place -- can easily cost upward of $25 million, he said. Plus, until a new lender establishes a track record and can turn to the securitization market, typically a three-year wait, the retailer would have to fund the loans it originates out of its operations or borrow the money. "If you're one of these large public groups, you have to say, does it make sense knowing you're going to have to fund it yourself for a while, or does it make sense deploying those funds into dealership acquisitions," he said. 

Jackson has answered that question for AutoNation, which has completed or announced dealership purchases this year that will add $1.7 billion in annual revenues. It's an acquisition spree bigger than any by the retailer since its formative years.

Jamie LaReau contributed to this report.