Many banking companies, challenged to find new growth platforms, have focused on indirect auto lending in recent years.
On the surface, this business is appealing. With new originations at $600 billion a year, it is a $1.5 trillion asset-backed lending market offering opportunity for rapid gains.
But instead of generating profitable growth, indirect auto financing has become an increasingly prominent source of negative earnings surprises.
In the case of some major players, like Bank One Corp., writeoffs have virtually wiped out profits in recent years. On Tuesday, American Banker reported that Bank of America Corp. had reorganized its auto leasing operations and closed the dealerships it had used to sell vehicles coming off leases because of losses from lower-than-expected resale prices for used cars ["B of A Puts Brakes on Auto Lease Business," page 1].
Three factors have been at the center of the industry's poor performance since the late 1990s: overestimations of market attractiveness, limited strategic differentiation, and poor understanding of profitability.
The best way to gauge a market's strength is profitability, not revenue size and growth. Indirect auto financing is a classic indirect market in which competitors write loans and leases through an intermediary - dealerships.
Despite the market's size and strong growth, structural forces such as the power of intermediaries, limited ability to differentiate, and customer price sensitivity severely hamper profitability.
Compounding these pressures are "captives" - finance subsidiaries such as Ford Motor Credit. These units provide 70% of the financing made by the industry's top 20 competitors, and they hurt the industry by forgoing profits in order to "move metal."
Many captives' incomes, when adjusted to remove manufacturers' subsidies, are well below the cost of capital. Given customer price sensitivity, this subsidization makes it very difficult for "pure-play" finance companies to make a profit.
To make matters worse, limited strategic differentiation has heightened price-based competition.
Many banks, hungry for growth, made the mistake of pricing ahead of expected scale advantages. In addition, many have a weak understanding of their own profitability.
The inability to disaggregate profitability has prompted broad, instead of focused, growth strategies. This has intensified competition and led to "bad" growth, as competitors have often built their businesses in least profitable areas.
Taken together, these factors have substantially slashed industry profitability and driven some competitors (most notably GE Capital) out of the business. So the real question is: Can banks make a profit in indirect auto financing? My answer is yes, but it will be hard.
Structural forces are likely to constrain the industry to a break-even level or a lower level. In this environment, staying in the business requires that top management be convinced that the company can create and sustain significantly profitable differences relative to the competition.
For most banks, this means they will need to evaluate their alternatives, including an exit strategy. The good news is that there are several alternatives:
Customizing: Exploit data systems to target customers and dealerships better in marketing, servicing, and pricing.
High-touch relationships: Develop a preferred-dealer relationship approach stressing superior support and flexibility.
Value-added partnerships: Provide information and promotional support to select dealers.
Preferred partner/private labeler deals: Be an exclusive finance partner for online car buying services or large dealerships.
Specialization: Participate in niche markets (for instance, used-car loans or long-term leases).
Companies failing to develop profitable strategies will need to get out of this business to avoid destroying shareholder value.
The recent partnership of J.P. Morgan Chase & Co., Wells Fargo & Co., Americredit, and DealerTrack to provide dealers with a Web application system will be an interesting test case. On the one hand, the new technology is a no-brainer, because it offers the potential to significantly improve operating efficiency. However, broadly sharing this technology could quickly erase any economic benefits.
The new technology may even erode industry profitability if it allows cost-disadvantaged players to become more competitive. Whether this technology can be leveraged to produce profitable differences for the partners' financing businesses remains to be seen.
Mr. Armour is a partner at Marakon Associates, an international strategy consulting firm in New York.
