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Too Many Franchises Spoil the Brand?

Front sign of Pontiac dealership, northern Michigan '09. photo/Quinn.anya

WASHINGTON — As the dust settled, the Obama Administration last summer issued a harsh report that was critical of the aggressive termination of franchises by General Motors and Chrysler during their bankruptcy proceedings. 

The government report declared that they felt hoodwinked by the franchisors' unexplored management myths: namely, the carmakers' claim that they were hurt by having many franchisees.

In the last few years a growing thought has been building up among American car manufacturers (franchisors) about their large car dealership (franchise) networks — they should copy the Japanese and go smaller. Where American carmakers have built up over 20,000 car dealerships from over a century of franchise development efforts, the newer Japanese car brands have gained tremendous market share with only a small fraction of the dealers (franchisees). The foreign distribution model has forced Detroit to consider the law of diminishing marginal utilities in franchising, that is to say, is there a point in which the marginal benefits of franchising is less than the marginal costs? Where is the point at which the benefits of more franchises just aren't worth the cost to not only the franchisees, but also to the franchisor?

Average annual sales by unit / source:Boston Consulting Group

Boston Consulting Group, Bain Consulting, A.T. Kearney and other consulting firms waded into the fray when they were asked to advise the Treasury Department on the best course of action to save the carmakers. Their answer was to aggressively shrink the number of dealerships to improve the health of the systems. The thinking was that fewer franchises would translate to better brand equity: with less competition within a brand, the remaining dealerships would have higher sales. With more sales volume covering costs, they'd be more profitable. And with other considerations, such as lower floor plan financing costs, the remaining dealerships could then afford more attractive facilities and better customer service.

GM and Chrysler answered by announcing an aggressive plan to eliminate dealerships.

For franchise sectors less mature than the auto industry, the thought seems heretical that there may come a saturation point at which selling more franchises hurts the brand. After all, franchising firms grow by selling franchises. Why should a franchisor care if a market gets saturated? If a franchisor sets up a sandwich shop only three blocks away from an older one, although the original franchisee's profits may suffer from customers who are siphoned off to the new location, the franchisor incurs little in costs but more royalty revenue because there are now two shops serving an enlarged footprint. Separately the two stores may have less business, but together they pay the franchisor more royalty. So where is the downside to a franchisor, other than a few complaining franchisees? automobile franchisor under normal circumstances would find it very difficult to terminate a franchise agreement.

Car franchisors came to the conclusion that consumers will drive extra miles to receive a two percent discount on the same product. They reasoned that when franchisees compete with each other, the discounted product price lowers the brand perception. Lower prices negatively affect the dealer's ability to service the customer, which in turn has dealers spiraling into more scrimping on services and products.

Each car franchisor's guess varied widely as to how much it would save by reducing its franchise network, with GM wildly expecting a huge $1.1 million savings for each closed dealership, while Chrysler anticipated a mere $45,500. Why the big difference? Because GM felt that having fewer franchises would enable it to reduce car incentives by a whopping $928,000 per franchise. Chrysler had no such assumption.

Car Dealers Historically Protected, until the Bankruptcies

While auto dealers' poorer cousins — fast food, fitness clubs, education centers or oil change franchisees — have largely been silent in advocating franchise relationship laws, automobile franchisees have been a powerful force in protecting their self-interests.They have pushed for franchise relationship laws for vehicle dealerships in every state and at the federal level, from Colorado's 1937 Anti-Monopoly Financing Law to the national Auto Dealers Day in Court Act of 1956.

Jim Moors, senior counsel to one of the most powerful lobbyists in the country, the National Automobile Dealers Association (NADA), which represents America's car dealerships, explained to Blue MauMau that all 50 states have enacted franchise statutes addressing the relationship between car manufacturer and franchisee. Dealers gathered together and formed state and federal franchisee associations that eventually could challenge the lobbying efforts of powerful car manufacturers. Nowadays each state has requirements that a carmaker has to meet if it wants to terminate a franchise agreement. Moors thinks that an automobile franchisor under normal circumstances would find it very difficult to terminate a franchise agreement.

But bankruptcy proceedings changed the status quo in favor of GM and Chrysler. It allowed the carmakers the rare opportunity to trim unwanted dealerships in order to right a sinking ship. Auto manufacturers announced that they would terminate ten percent of their dealerships, largely in cities where dealers were located too close to one another, competing with each other.

Car manufacturers set up performance criteria to separate the dealership wheat from the tares. Carmakers said that they would eliminate dealerships based on low profitability, low customer satisfaction scores, low capitalization ratios and violations of operating standards, like displaying improper signage or selling the wrong car product.

chart:bmm / source:sigtarp

GM terminated 1,454 dealerships, accelerating its original reduction of dealerships plan, which called for 300 per year through 2014. Chrysler terminated 789 franchises.

As car dealer terminations took off, NADA played a significant role in giving franchisees the opportunity to present their side of the issues to Congress.  A statute was passed that gave dealers that were targeted for termination the opportunity to either sign or reject wind-down agreements, and to present their cases in arbitration hearings. As a result, GM offered to reinstate over 650 dealerships. Chrysler offered to reinstate 50.  

NADA's senior counsel Moors thinks the passage of the federal statute was a significant victory for dealers, but adds, "There were a number of brands that went away, like Pontiac. There was nothing that could be done about them."

In the end, just 700 were terminated, a far cry from the original cessation notice given to thousands. Still, it wasn't the metropolitan dealerships that suffered the brunt force of the axe as originally planned, but rather rural dealerships with the weakest scores. Of all terminations, 44 percent were in rural areas, the largest group by far. And it is the rural closures that have civil planners, legislators and economists worrying that the shutterings are having the worst impact where jobs are needed most.

Ed Tonkin, chairman of the National Automobile Dealers Association, thinks the widespread closures were a mistake. "Rapid dealer reductions increase unemployment, threaten communities and decrease state and local tax revenue without any material corresponding decrease in the auto maker's costs," he declared. Tonkin went on to say that the government did the right thing by giving thousands of dealers the opportunity to have a neutral arbitrator review their cases and possibly save thousands of jobs. He concluded: "The franchised automobile dealership is and will continue to be the most powerful job-creating entity on Main Streets all across America."

"Rapid dealer reductions increase unemployment, threaten communities and decrease state and local tax revenue..."

Tonkin isn't alone in his concern about chopping dealers. The Special Inspector General for the Troubled Asset Relief Program, Neil Barofsky, had his department audit the situation. It reported (pdf) that it was a roll of the dice to give heed to an unproven management theory on how terminating franchises might raise the economic viability of the franchisors. But more importantly, there was also a missed economic issue. The closed dealerships would cause the ranks of the unemployed to rise by tens of thousands, not in the cities, which are better situated to absorb them, but in small town America.

The Department of Treasury's response to the investigation was that it did the right thing in shrinking the dealership network. "Both GM and Chrysler have emerged as stronger global companies," the Treasury answered.

2010 Franchisee Sales, Franchisor Profits Up

There is good news for the industry of late. Reuters reported last week that average vehicle sales for car dealers are anticipated to rise 14 percent in 2011.


And what about the carmakers who have shrunk their franchise network?

Yesterday General Motors announced that its 2010 annual report showed its first annual profit since 2004, a whopping $4.7 billion. Ford made even more, $6.6 billion, its largest profit in a decade. And although Chrysler had losses in 2010, which it blames on the government bilking it with extraordinarily high interest charges for floating it money during its bankruptcy, the carmaker expects profits soon. "We will be bottom-line profitable in 2011," chief executive Sergio Marchionne declared to the Detroit News.

Paul Eisenstein of The Detroit Bureau, an independent auto news service, explains to Blue MauMau that the answer to what caused the recent uptick in sales for dealers and the increase in profits for franchisors is yet uncertain. "Simply focusing on slashing the distribution network would not have achieved much," he concludes.

But the industry watchdog admits that there is some truth to the argument that Detroit's franchise system was bloated and needed rationalizing. "Working with fewer dealers and focusing them on the competition, rather than having them fight with retailers representing the same brand, appears to be working to some degree," says Eisenstein.

A reporter on the car industry for over 30 years, Eisenstein observes that the Big Three are now paying closer attention to the fundamentals of their dealers' businesses, such as inventory size, financials and business costs. "Makers have recognized the need for healthy dealers," he states.

Eisenstein thinks it is important to consider that Detroit is also delivering better products and getting higher prices. "The Chevy Camaro and Equinox, for example, and the Ford Fusion and new Explorer, are generally delivering higher average transaction prices, which directly and immediately impact the bottom line," the veteran correspondent observes.

When all is said and done, did reducing the total number of franchised locations in 2009 add to the recovery of these insolvent car franchisors? It may still be some time before we know.

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About BMM

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Staff reporter for Blue MauMau