auto leasing

I’ve been reading an article in the Wall Street Journal this morning reporting Fed data that indicates auto loan defaults are on the rise in the US, particularly in poorer areas in the southern US.  This follows recent comments from automakers that the market for new cars is peaking and from used car dealers that prices declined last year and will dip further in 2017. Part of the downward pricing pressure is due to a larger number of cars coming off lease.

car leases

All this should come as no surprise, since the auto industry is cyclical and we’re closing out year eight since the US economy bottomed in 2009.  If there is still a shoe to drop–and I think there is–it will come in the car leasing market itself.  Here’s why:

Let’s say I want to buy a $30,000 car on a three-year lease.  What determines my lease payment?

The leasing company buys the car I want to lease from the auto company and rents it to me.  Its charges consist of:  interest on the purchase price; recovery of the loss in value of the car over the lease period; and the price at which the leasing firm figures it can sell the car for at the end of the lease.  The key figure here is the lender’s estimate of what the car will be worth when I turn it in.  This is called the residual value.

Examples:

1.  The lender estimates the car will be worth $15,000 in three years.   At 4% interest, that’s a monthly payment of $490.  In total, I’ll pay $2743 in interest charges (an average of $76/month) over the three years and $15,000 in principal.

2.  If the car is estimated to be worth $20,000, that translates into a monthly payment of $360, with a total of $10,000 repayment of principal + $3029 in interest ($17.50/mo).

At rates close to zero, an interest rate change makes little difference.  The difference between $490/month and $360 is the residual value assumption.

(Note:   real world leases can be much more convoluted, but these are the economic basics.)

how leasing companies get into trouble

Historically, lenders–and especially those affiliated with automakers–have made the residual values too high.  Why?  To my mind, it’s because a lower monthly payment (i.e., a higher residual value estimate) makes the car sale easier.  In the moment, the day of reckoning appears to be far in the future.  It can also be that the accounting framework the lender uses permits assumed profits on new loans to offset realized losses on old ones.  If so, as long as lease volumes increase, reported profits probably won’t reveal the damage being done.

Experienced auto stock investors are doubtless already worrying about the potential negative effects of leasing.  I imagine, though, that as/when the issue becomes better known–that is, when writeoffs from leasing operations start to emerge–this will be more bad news for auto stocks.

 

Elon Musk’s master plan for Tesla (TSLA)

Last week, Elon Musk issued his second master plan for TSLA as a blog post on the company website.

The plan has four parts:

autonomous driving, with the goal of making self-driving cars 10x as safe as those operated by human drivers.  The main issue here is, according to Musk, compiling enough safety date to convince governments to allow autonomous driving on public roads

expanding the product line, to include pickup trucks and compact SUVs, plus heavy trucks and urban buses.

Although what he writes on this topic is not 100% clear, one goal under this heading seems to be to reinvent the auto manufacturing process in a way that the new/improved factory is 5x – 10x as efficient as current ones.  One ambiguity I see is whether this means 10x the efficiency of, say, a Toyota plant, or 10x the efficiency of the current TSLA operation.  I presume he means the former.

Another is exactly what “efficiency” is.  I’m taking it to mean that Musk intends to create factories that, for the same capital investment, will produce 5x – 10x as many cars in a given time as current factories do.  My cursory inspection of auto 10Ks (other than TSLA, I don’t think I’ve owned an auto stock since the 1980s) tells me this won’t mean a huge jump in unit profits for any auto firm, including TSLA, since most of the costs of making a car are in materials and labor, not capital equipment.  Greater efficiency would boost overall profits, however, as well as allow TSLA to dramatically increase its vehicle output.

sharing.  Musk thinks that in an era of autonomous driving, some people won’t own cars themselves anymore.  They’ll simply call for one from a sharing service when they need it.  Other people will own cars but will allow their vehicles to be used in a sharing service when they don’t need them.  TSLA intends to organize sharing services for its vehicles.

This is a much more revolutionary statement than it seems.

The average car is used only 10% – 15% of the day, according to Musk.  If sharing boosted that usage figure to, say, 30% in highly populated areas, then those regions would need only half the cars they do today   …maybe fewer.  At some point, this would mean an implosion in demand for new autos–and the end of the car manufacturing industry as we know it.

merger of TSLA and SolarCity (SCTY).  In his Master Plan, part deux, Musk says he wants to create a “smoothly integrated and beautiful solar-roof-with-battery product that just works, empowering the individual as their own utility, and then scale that throughout the world. One ordering experience, one installation, one service contact, one phone app.”

He says this can’t happen while TSLA and SCTY are separate companies, something he describes as “an accident of history.”

I’m not sure I buy this.  I do think that Musk created clear economic superiority of TSLA over SCTY when he decided to place the Gigafactory for solar batteries inside TSLA.  To my mind, that makes SCTY radically dependent on TSLA today.  Merging the two companies would put SCTY back on an even footing.  For TSLA shareholders, arguably the main benefit of the combination is obtaining SCTY at a cheap price.