What is the future of the franchise system? Dealers cautious but optimistic

Dealers looking out on the horizon see many bumps and uncertainties ahead for the franchise system. The bigger the automotive retailer, the smaller those bumps may be. But the challenges -- ranging from car sharing to online selling -- will be faced by all.

The list of concerns is long. Certain scenarios have some dealers worrying about permanent damage to the franchise model. For instance, will the battles over Tesla's push to sell its cars in factory stores lead to weaker franchise laws and other automakers attempting direct sales? Will car-sharing technology and self-driving cars converge to weaken consumer demand to own vehicles?

Other pressure points, near- and long-term, include:

• Automaker sales programs and dictates for facility investment 
• Dealership consolidation and the struggle for smaller groups to keep up 
• Regulatory crackdowns on lending and advertising practices 
• Slimmer vehicle margins as Internet competition drives down prices 
• Difficulties in hiring and retaining dealership staff. 

"It's not all green. It's not red. It's like a caution light is there, and it could go either way," said Mitch Walters, owner of Friendship Family of Dealerships, a Bristol, Tenn., group selling 10 new-vehicle brands. "It really depends on the economy, the manufacturers and how the government allows other automakers to enter the market." 

That uncertainty was echoed by many dealers. But at the same time, dealer after dealer and their representatives at NADA and state dealer associations express optimism -- in some cases, outright confidence -- that the future of the franchise system is secure.

"Sure, there'll be lots of changes around the edges," said Peter Welch, president of NADA. "But the system is robust as ever. Consumers' love affair with the automobile is much stronger than most people will admit."

Welch, though, adds another concern that could threaten industry sales and dealership coffers: Affordability. NADA has spoken out against the federal fuel economy targets that it says could make new vehicles too expensive for many of today's customers.

But for now, the market is healthy. Dealers have enjoyed several years of robust sales and profits. Light-vehicle sales in the U.S. set a record in 2015, only to top it with 17.5 million sales in 2016.

Coming out of the Great Recession, average dealership profits as tracked by NADA rose for six straight years, reaching a record in 2015. But the streak could be ending. Through October, average dealership pretax profit fell 6.2 percent.

Though dealership valuations are still high, they also may be starting to ease off record levels, buy-sell advisers say. Even so, interest in buying dealerships from outside investors remains strong. Billionaire investors Warren Buffet and George Soros have both bought into dealerships.

Even through the good financial times, the dealership franchise model has received an extraordinary dose of public scrutiny. The Federal Trade Commission held hearings in early 2016 to examine franchise laws, including those at the state level. The closer looks largely have been triggered by Tesla Motors' attempts to open factory stores across the U.S. Dealers have battled Tesla in many states to stop the stores, saying state franchise laws prohibit direct sales by an automaker.

For many dealers, the concern is that Tesla will establish a precedent that could lead to other automakers, those both new to the market and perhaps even legacy manufacturers with existing dealer networks, selling directly. Tesla is suing Michigan in federal court over the state's ban on direct sales. 

"I'm more concerned, not so much about Tesla, but about the notion of the factory selling direct," said Don Hall, president of the Virginia Automobile Dealers Association. "It opens up the Pandora's box." 

With the public and some lawmakers sympathetic to Tesla's position, dealers have given up ground in several states. In New Jersey, New York, Ohio and other states, compromises have been struck allowing Tesla to operate a certain number of stores in the state. But the compromise legislation generally is written in a way that it blocks other automakers from following in Tesla's footsteps. 

The Alliance of Automobile Manufacturers, which represents 12 automakers but not Tesla, and automakers such as General Motors have pushed back, saying if Tesla gets the right to sell directly, other automakers should have that right as well. They also say state franchise laws have tilted the balance in the automaker-dealer relationship too far in favor of the dealer. Dealers counter that, saying automakers actually have too much control.

Factory control is a hot button for most dealers.

Mike Jackson, CEO of AutoNation Inc., the country's largest new-vehicle retailer, identifies the top threats to the franchise system in the near term as "discriminatory, illegal pricing schemes" and questionable sales reporting practices by automakers.

The combination can lead to falsified sales as retailers are rewarded for meeting volume targets. It creates multi-tier pricing and hurts consumers and retailers, Jackson said.

"I talk to manufacturers. Here's what I say: "Your customers are unhappy, your resale values are going to go down, and your brand is damaged. It's unsustainable,'" Jackson said.

Some pressures on dealers have been around for a while and will continue, said Craig Monaghan, CEO of Asbury Automotive Group Inc., which ranks No. 7 on Automotive News' list of the top 150 dealership groups based in the U.S.

"The web is going to continue to provide incredible transparency. Both new and used margins are going to remain compressed. Interest rates are going to increase; that's inevitable. Stores will continue to need capital; things wear out. We're going to have to make these investments. And we're going to be in a marketplace where there's a lot of competition to attract and retain talented people," Monaghan said.

The threats are severe enough that NADA in 2016 commissioned a study to look at the state of dealerships in 2025. Consultant Glenn Mercer, a former McKinsey & Co. partner who previously studied automaker facility programs for NADA, conducted the study. It was geared at getting dealers planning around the challenges they'll face. (See story, Page 130.)

While those challenges are many, they aren't crippling, Mercer concluded.

"Dealerships will see continuous evolution over the next 10 years but most likely not revolution," Mercer said.

Mercer flags the convergence of car-sharing platforms and self-driving vehicles as posing the greatest risk to franchised dealerships. Dealers will suffer if consumers move away from car ownership in favor of such services, he said. But they also could benefit if autonomous driving technology enables the purchase of vehicles for older people or children who cannot drive themselves.

The risk to dealerships grows after 2025 as competition intensifies and new technologies have more time to trigger challenges for the franchise system, Mercer said.

Jim Appleton, president of the New Jersey Coalition of Automotive Retailers, urges dealers to look at some of the developments as opportunities.

"Car sharing and ride sharing are networks that dealers could provision," Appleton said. "In New Jersey, I could see dealer-branded car sharing and ride sharing programs operating in densely populated parts of the state."

Single-point dealerships and smaller groups are more vulnerable in the years ahead. Mercer predicts that the number of U.S. dealerships will drop from just under 18,000 stores today to around 16,500 in 2025. And the pool of dealership owners will drop from 8,000 today to 6,500 in that same timeframe. Capital investment and training needs will increase, and the operations requirements will become ever more complex.

"It seems like every day I've got somebody calling me up saying it's no fun anymore," Welch said. "The factory programs are too rigorous, and the only way you can make money is on these manufacturer incentive programs, stair-step programs and others."

John McEleney, NADA chairman in 2009, called it a wrap in 2016, his family's 102nd year in the business.

After having as many as six dealerships, McEleney was down to one store in Clinton, Iowa, that he ran with his son. The dealership performed well, but when a bigger retailer approached the father-son pair about selling, the deal made sense, said McEleney. The challenges facing franchised dealers were part of the decision-making, he said.

"It's clear that consolidation is coming," McEleney said. "We were in a midsize market, and we had good franchises. Our facilities were current. We had a lot of things going for us, but looking down the road, you either have to acquire or be acquired."

McEleney, who turned 65 in October, was reaching retirement age. Son Drew, now age 36 and with a young family, decided against becoming the acquirer. So in July, the McEleneys sold their store to Billion Automotive, which bills itself as family owned and "one of the nation's largest automotive websites." Drew McEleney now works for Cox Automotive.

Economies of scale will continue to drive consolidation, Asbury's Monaghan said. The consolidators have access to cheaper capital and get significant price breaks from vendors. They also are able to hire in-house experts in areas such as technology and human resources that small groups often cannot.

"We can commit the capital to the stores. We don't have to worry about family estate planning issues or generational transitions. We're in this for the long haul," Monaghan said. "It's becoming more and more challenging to run a stand-alone car store."

Though many of the changes happening in the industry are daunting, dealers can adapt, said Jeff Carlson, a Colorado dealer and 2016 chairman of NADA. Their ability to do so is why the franchise model already has worked for more than 100 years.

"The reason dealers are able to survive is because we compete furiously, and we have to reinvent ourselves every single day. If the manufacturer announces an incentive, we have to adapt, and if he takes it away, we have to readapt, and if there's a new regulation, we have to adapt," Carlson said. "And if we have a new model of mobility that comes out, it may take us a few days -- but we'll adapt. We are very rapid changers. We mutate or die."