Will Direct-to-Consumer Sales Surpass the Franchise Dealer System?

Tesla, Rivian, Lucid and Polestar. These brands are getting a great deal of attention right now, and not simply because they sell electric vehicles. They also offer consumers the opportunity to purchase vehicles “direct from the factory.”

What if traditional manufacturers want to change from a franchise system to direct sales? There  are major obstacles to achieve such a change, some financial and many legal. The bountiful margins at retail lead many to believe the direct-sales approach is the future. But, more than anything, those rich margins result from where we are in a unique sales and production cycle. Because there is so little inventory on the ground currently, total profits per unit for the retailer remain off the charts.

The multibillion-dollar question is whether the current situation represents the future. Driven by pandemic-related supply chain shortages, the ultra-tight inventory situation of the past three years drove retail margins to unprecedented levels. But pursuing the direct approach would be the wrong decision for the long haul.

The reason? Things change. A tight inventory situation strongly favors direct sales. Vehicles sell almost as rapidly as they are manufactured, so the carmaker need not worry about cash tied up in unsold inventory. But as vehicles become more available and inventory builds, car manufacturers who sell direct find increasing amounts of their funds stuck in inventory. That, essentially, is the downfall of the direct-to-consumer sales model. A slow-moving sales market with many cars on the ground can choke a manufacturer's cash flow that is needed to fund operations and develop new models.

On the opposite side of the coin, one of the key benefits of the franchise dealer system from the manufacturer's point of view is that it holds inventory. In the franchise system, manufacturers don’t finance inventory through the final sale to individual consumers. Their dealers – who are the manufacturers’ customers – bear that burden.

And that’s no small burden, to be sure. Inventory that sits on the balance sheet ties up cash that otherwise would go into running other aspects of the business. In the old days, when there were 3 million-4 million units on the ground, the dealer body was instrumental in taking those units off the automakers’ books, allowing the automakers to take profit immediately when they shipped vehicles to their dealers.

The franchise dealer system also creates regional and, in some cases, hyper-local retail prices. Across the country, consumers have different preferences based on where they live and the conditions they encounter. The dealer-by-dealer flexibility in price meets consumers exactly where they are. Direct sellers, who most often set retail prices nationally, don’t have that luxury.

The decision to institute direct sales or remain with the traditional two-tier dealer franchise system depends on what the industry will look like going forward. To those who believe the future will be closer to what it is today than what it was in the past, the direct-sales model appears to be the better choice.

But to those who believe carmakers will not be able to keep a lid on production, the franchise dealer system remains the right approach. Excess capacity could again become an issue two or three years down the road. The direct-to-consumer model has a lot of advantages, but its biggest weakness is that it does not work well in a situation with excess inventory.

One thing we know about the auto industry is that consumers like to shop from inventory at dealerships. So even though some proclaim a brave new world where we don’t have inventory, if one automaker retains the franchise dealer strategy it is very difficult for competitors to succeed with a direct-to-consumer, small-inventory model.

If a consumer wants to buy a pickup truck and is told it will take eight weeks to build it and no discounts are available, think about what will happen when that consumer sees a dealership across the street with the traditional business model. That dealership has a wide variety of pickup trucks on the lot with significant discounts. The consumer’s choice will be obvious. Pay less and get it now? Of course.

For this and other good reasons, we’re not likely to see direct sales from the existing automakers. There are too many inherent advantages to the franchise model. We might see some give and take between the two sales philosophies in the future. But we expect franchise dealers will exist long past our respective lifetimes.

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Tyson Jominy (pictured left) is vice president of data and analytics at J.D. Power.