With all the doom-and-gloom talk floating around, F&I Director Marv Eleazer said his Valdosta, Ga.-based Langdale Ford Company has a policy. “Our dealership chooses not to participate,” he said.

Despite troubles in new-vehicle sales and automakers turning to incentive programs and extended warranties to remain competitive, dealers and F&I providers alike say it’s a good time to be in the vehicle service contract (VSC) business. However, one analyst said the very thing that’s helping dealers move vehicles is the same thing that’s helping F&I managers move more F&I products.

“One explanation for rising [VSC] penetration that I’ve heard is menu selling,” said Jesse Toprak, senior analyst for Edmunds.com. “Another factor that’s enabling aftermarket product sales is extended terms.”

Ann Tomlanovich, director of Chrysler Service Contracts, said the company’s service-contract sales are doing well with maintenance, convenience and GAP plans tripling since 2002. Now she faces the prospect of continuing the service unit’s growth despite Chrysler rolling out a new lifetime powertrain warranty in late July. However, she’ll be doing so with a lifetime mechanical coverage program wrapped around the new factory warranty.

“The new mechanical coverage is clearly the most expensive plan we offer,” she said. “Happily, I can say that a week into the new powertrain warranty and we’re selling quite a bit of them. Extended loan period could be helping that.”

While there is no direct data to link extended terms to VSC sales, loan terms are stretching out. According to the National Association of Finance (NAF)’s 2007 Nonprime Automotive Financing Survey, 76 percent of new-car contracts were longer than 60 months. The Consumer Bankers Association (CBA)’s 2007 preliminary study, released in March, showed 61 percent of new-vehicle loans were longer than 60 months, up from 55 percent last year and 45 percent in 2005.

Toprak sees average terms standing at 63 months, and said 72 months is quickly becoming the norm. Another trend he’s seeing is dealers, feeling the pressure to move vehicles, sacrificing front-end profits in hopes that their F&I departments can make it up on the back-end. Not a new way doing of business, but Toprak sees it intensifying.

“The importance of the F&I office won’t diminish in the foreseeable future. It’s quite the opposite; there will be more burden of dealership profit on F&I,” he said. “Our internal numbers show that front-end profits have been declining in the last six years.”

Finance reserve is also on the decline, according to the CBA’s 2007 preliminary study. While competition on the lender side is partly to blame, a series of lawsuits against the industry for allegedly charging minorities higher rates on auto loans could also be impacting reserve. Eleven of those lawsuits were settled as of April. The industry is also dealing with the spread of the Car Buyer’s Bill of Rights since it went into effect in California last July. It set finance reserve caps at 2.5 percent for loans of 60 months or less, and 2 percent on loans of 60 months or more. Illinois, Massachusetts and Minnesota are other states that have considered or are considering similar legislation.

Also hurting dealer profits is the Internet, enabling consumers to shop across states for the best price. The situation is putting more pressure on regions, forcing dealers to compete on price at a national level. Toprak said he doesn’t expect the loss of front-end profits to end anytime soon, especially as automakers look to use incentives to clear out current model-year vehicles to make room for 2008 models. As he said, most vehicles are hitting the lots with incentives already attached.

“It’s concerning, but that’s the reality of today,” he said. “F&I guys have more to fall back on because they have more to sell. I think the greatest pressure is on the salespeople whose salary is based on front-end profits. Those are the ones who have to worry the most, because this trend is not going to get any better.”

Dealerships Counting On F&I

The focus placed on F&I is nothing new. After falling from 1998 to 2005, gross margin on new-vehicle sales rose 2.3 percent in 2006, according to the 2007 NADA Data report. Aftermarket income made up 27.6 percent of new- and use-vehicle department gross in 2006, up from 26.3 percent in 2005.

Penetration of VSCs is also on the rise since it hit its lowest point in 1998 at 20.1 percent. Penetration reached 32 percent in 2006, closing in on the 35-percent high registered in 1986. F&I providers and industry experts have been preaching to dealers the impact VSC penetration can have on other aspects of the dealership, namely service and parts. And dealers have responded.

Sid DeBoer, chairman and CEO of the Medford, Ore.-based Lithia Motors, partly attributed the group’s 11-percent increase in second-quarter earnings to parts and service sales.

“The highlight of the quarter was Lithia’s parts and service business, which continued its strong performance with same-store sales growth of 4.6 percent on top of 8 percent growth in the second quarter of last year,” he said in a press release. The company’s F&I profit per vehicle also increased by $43 in the first half of this year when compared to the same period last year.

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Statistics also point to the impact F&I is having on service drives. The Bandon, Ore.-based CNW Marketing Research reported that 29.31 percent of those who purchased a service contract returned to the issuing dealership for maintenance. That percentage dropped to 10.46 percent for those who did not purchase a service contract. Data also showed that service contracts made up 30.7 percent of F&I profits as of June, which is a decrease from the 32.7 percent reported last year.

However, across the board, both captive units and aftermarket F&I product providers report that the VSC market is booming.

Feeling the VSC Boom

“I would say it’s a good time to be in the [VSC] business, because I think our dealers have picked up a whole lot of interest in what’s going on in F&I,” said Chrysler Service Contracts’ Tomlanovich.

She said the average penetration rate for Chrysler’s service contracts on new vehicles is 24 percent, and 22 percent for used and certified pre-owned plans. F&I managers are also averaging 30-percent penetration on maintenance, convenience and GAP. She also reported that 64 percent of sold plans cover all mechanical parts, while 32 percent of plans sold cover powertrain and other major mechanical components (e.g., air conditioning, electrical, etc.). However, only 4 percent of plans sold covered powertrain alone. As for the most popular term, Tomlanovich said the 7-year/70,000-mile term is the most popular, with the most common deductible being $100.

As for product mix, she said Chrysler is 35 percent mechanical plans, 36 percent maintenance, convenience and GAP, and 29 percent pre-owned. She said dealers should aim for 35- to 50-percent product penetration on new vehicles (mechanical and maintenance/convenience).

Aftermarket companies are also experiencing a booming market for F&I products.

Jim McDavid, JM&A Group’s vice president of North American Sales, said the majority of contracts sold are the more comprehensive to full-coverage contracts, or what the company terms as Gold Plus and Platinum coverage. Only a small percentage of powertain-only coverage is sold. As for the company’s most popular term, McDavid said 84-month/100,000-mile coverage seems to be moving the best. And like Chrysler, the most popular deductible is $100.

“Service contract sales follow very closely with top vehicle sales markets, such as Los Angeles, Chicago, Dallas and the Northeast region,” he said.

McDavid added that the average price paid by consumers for VSCs ranges between $750 and $3,500, depending on make, model and coverage. As for what he considers good performance for a dealer, McDavid said VSC penetration in the 45- to 50-percent range is good.

“We had record sales last month,” said David Muhonen, senior vice president of risk management for CNA National Warranty.

The Scottsdale, Ariz.-based company reported in July that inception-to-debt payments totaled more than $10 million paid to dealers nationwide for the company’s Dealer Equity VSC reinsurance program.

“We put together a structure where our ratings were based on a series of factors. Anything we can anticipate in terms of levels of coverage and deductibles, all we have to do is throw a few switches,” Muhonen said. “The basic idea is stay light on your feet … be able to react.”

The most profitable plan, said Muhonen, was one that doubled the 3-year/36,000-mile factory warranty. As for competing against extended factory warranties, he said there are plenty of other areas where coverage can wrapped, especially with the onset of new vehicle technologies. Warrantech Automotive Inc. President Chris Ford agreed.

“There’s a reason for that,” said Ford. “Twenty-five years ago 80 percent of claims were powertrain. Today, it makes up less than 50 percent. Today it’s computers, air conditioning, high-end electronics, navigation systems and car management systems. Those are the most expensive claims, and most of it can’t be repaired.”

Premiums have also lowered, reported dealers, with VSC providers acknowledging that the lengthening in factory powertrain warranties reduced their exposure. This is allowing dealers to offer service contracts at lower monthly payments, while allowing providers to cover more electronic components. This comes at a good time with automakers increasingly looking to compete on items such as extended warranties.

Vehicle Quality to Improve

For automakers, extended warranties have become a way to get their competitive message out. For Hyundai, the 10-year/100,000-mile warranty it rolled out in 2000 turned the company’s image around. And in July, the company announced that it hit the five-million-mark for U.S. sales.

Ford jumped in the game last July when it lengthened its powertrain warranties on 2007-model-year Ford, Mercury and Lincoln vehicles. Despite lengthening its warranty, the company reported that it cut warranty costs by $700 million for the first six months of this year.

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Chrysler, which began phasing out its 7-year/70,000-mile warranty with its 2006 model-year lineup, is now looking at a new lifetime powertrain warranty to give it that competitive edge. And like Ford and Hyundai, the company will also look to cut warranty costs, which Automotive News, citing regulatory filings, put at $6.1 billion globally. General Motors reported $4.46 billion in claims last year, Ford $4.10 billion and Toyota $2.37 billion. Honda paid $960 million in claims.

In J.D. Power and Associates’ annual Vehicle Dependability Study, which measures problems experienced by original owners of three-year-old vehicles, the industry average was 216 problems, down from 227 in last year’s survey. The 2007 survey gathered responses from 53,000 vehicle owners.

Buick tied with Lexus as the highest ranking brand with 145 problems per 100 vehicles, the first time in 12 years Lexus shared top honors. Rounding out the top five brands were Cadillac, Mercury and Honda. Land Rover was the worst-performing brand with 398 problems.

Looking further into vehicle quality improvement, J.D. Power and Associates’ 2007 Service Usage and Retention Study revealed that 62 percent of car owners surveyed came to dealerships for routine maintenance. Only 38 percent of the 84,500 surveyed owners of 2004, 2005 and 2006 vehicles said they required actual repair work.

“Whether consumers are aware of it or not, the fact that vehicle quality is continuing to get better, the need for repair work is on the decline,” said Thomas Gauer, senior director of Automotive Retail Research for J.D. Power and Associates. “The percentage of just maintenance is on the rise, but the percentage of those coming into dealerships for repair work is continuing to trend down.”

Extended Warranties, No Problem

In January, after experiencing declines in VSC sales for all of 2006, Langdale’s Eleazer walked into his dealer principle’s office and presented him with a revised pay plan that would reward him for increased net profits. Since then his numbers have taken off, primarily in service contract sales, where Eleazer’s penetration has gone from 35 percent last year to 42 percent this year.

He agrees that longer terms help with F&I product sales because they decrease the monthly payment, but he said using extended terms is just part of normal business. What amazes him more are the odd terms lenders are rolling out, such as 75-month terms instead of 72, or 63 months instead of 60. Bottom line, he said, F&I product sales really come down to sales technique and selling the dealership’s service department.

“Whenever I have a customer buying a vehicle, I tell them, ‘We have five master technicians working on cars. Are you buying a quality product? Of course. Is it subject to breakdown? Of course. It’s made by man. I’m just arming you with facts to make an intelligent decision,’” he explained. “It’s just that plain and simple.”

Most F&I managers will talk about increased penetration of F&I products. But they will also talk about the challenges being felt with the lack of new-vehicle sales.

Chris Cipriano, F&I manager for Saturn of Raynham, Mass., said every deal these days has been a grind. Not because of the onset of factory extended warranties, but because of a lack of deals.

“I just take it day by day and hope it doesn’t get any slower,” he said. “Problem is, there’s no rhyme or reason for what’s going on. Sometimes there’s nothing, then all of a sudden I have 10 deals.”

Working for a Saturn dealership where front-end profits are fixed, Cipriano said he feels the pressure even more. Currently, his service contract penetration stands at 57 percent. He’s also at 45-percent penetration on GAP and 63 percent on finance. Still, many of his customers from his predominantly middle-class location are falling into the subprime category; others are coming in looking to pay cash.

Diversification has been the key for many mega franchise dealers this year. Penske saw second-quarter revenues increase 19.2 percent, including an 8.5-percent increase in same-store retail revenues. F&I increased 7 percent for same-store revenues. Sonic Automotive attributed its increase in gross margins to higher-margin used vehicles, fixed operations and F&I.

Asbury Automotive Group saw profits rise 8 percent despite a soft retail sales market. Finance penetration was up three points, as was VSC penetration. “Retail sales, both new and used, were soft during the quarter, but thanks to record results in finance and insurance, both in total revenue and on a per vehicle retailed basis, and solid results in fixed operations, we were again able to deliver record earnings per share,” said Charles R. Oglesby, president and chief executive, in a statement.

Second-Half Challenges

So far, reports have been mixed on what retailers face heading into the make-or-break fall selling season. Falling gas costs held U.S. consumer prices nearly in check in July and industrial output rose, suggesting that the economy was sound despite credit fears in financial markets. Analysts said the latest data, combined with reports earlier in August showing solid retail sales and a shrinking trade deficit, point to a strong economy. Still, many fear the industry has yet to feel the fallout of the subprime mortgage industry.

In August, the Dow Jones reported that Ford Motor Co., General Motor Corp. and Toyota Motor Corp. were already reducing projections this year. Ford and GM now project 16.5 million vehicles sold this year, a drop of almost one million from last year. Light-vehicle sales are projected at 16.1 million, the lowest since 1998. Toyota expects light-vehicle sales to reach 16.3 million, only slightly higher than the other companies’ projections.

The California Motor Car Dealers Association (CMCDA) also reported in August that new-vehicle registration in California declined 7.7 percent in the second quarter of this year, compared to the same period last year. It attributed the decline to higher fuel prices, a softening housing market and debt-conscious consumers. However, it said in a statement that it expects the rate of decline to ease in the second half of this year.

“I remain convinced that this economy is strong enough to support 16.5 million units, but the airwaves are full of unhappy talk about the real-estate market,” said Paul Taylor, NADA’s chief economist. “The new-car side is very difficult right now, and the used-car side has to perform well, along with parts and service, for a dealership to be profitable.”

One thing dealerships can count on is the strength of the F&I product market, said Warrantech’s Ford. He predicts the business will grow even bigger in the next five years

“The business is 35 years old and it still hasn’t matured,” he said. “There’s still a lot of room for innovation, new ideas. I think you’re going to find more players, larger players interested in getting into the business.”

About the author
Gregory Arroyo

Gregory Arroyo

Editorial Director

Gregory Arroyo is the former editorial director of Bobit Business Media's Dealer Group.

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