Autos

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

Britons are famed for their obsession with buying houses. Now another bubble looks poised to pop -- but this one is made of steel and rubber, not bricks and mortar.

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New car sales data due out Thursday are expected to show vehicle registrations hit a record high of more than 2.6 million in 2015, beating the previous record of 2.58 million set in 2003. Until a wobble in October, new car sales had expanded for a record 43 months -- a far longer rate of expansion than in the rest of Europe.

These extraordinary figures provide a false picture of the market's health and may be setting the industry and investors up for a nasty hangover. Here's why.

U.K. New Car Registrations Keep Rising
But PCP contracts and "pre-registrations" spell trouble for used car values
SMMT
2015 value is EY estimate

Together with an improving economy and rock-bottom interest rates, new car sales are being spurred in the U.K. by a financing arrangement known as the Personal Contract Purchase.

About 75 percent of cars purchased by retail customers in the U.K. are bought with some form of financing. Of that, PCP accounts for three-quarters, up from two-thirds in 2013, according to the Finance & Leasing Association.

In a PCP, customers make an upfront payment and then a series of comparatively low monthly installments, which mostly cover the expected depreciation of the vehicle. As some luxury cars depreciate more slowly than their lowlier peers, they have become cheaper for consumers to buy with PCPs. (A Range Rover Evoque can be yours for a 7,670-pound down-payment and 36 monthly payments of 399 pounds, rather less than the 36,600-pound sticker price.)

Land Rover's U.K. car sales rose 17 percent in first 11 months of 2015, as did Mercedes Benz's. Jaguar's sales climbed 29 percent, according to data from the Society of Motor Manufacturers and Traders.

Car dealers love PCPs because they encourage buyers to purchase a new car more frequently -- and keep coming back. That's because after three years, the contract gives customers a choice: pay the outstanding balance (and keep the vehicle), part-exchange the car for a new model or simply return the car (and pay nothing more).

Because PCP contracts specify a guaranteed residual value at the start of the contract, they transfer the risk of the residual value of the new car dropping from the consumer to the finance company -- often a subsidiary of the carmaker.

Another factor revving up the market is the dealers themselves. They're under huge pressure to meet sales targets set by the manufacturers, and get their commissions. But many of these "new" car sales are "pre-registered" cars, where a dealer sells the vehicle to himself and then re-sells the same car to a customer at a much lower price. The manufacturer and dealer can keep volumes climbing.

But at what cost? John Leech, a partner at KPMG who specializes in the automotive industry, says in normal circumstances about 2.3 million new cars would sell in the U.K. annually. But with PCP and pre-registration sending that figure to 2.6 million, the industry is putting pressure on the used car market.

Until now, the supply of used cars has been kept in check because fewer people bought new cars in the wake of the financial crisis of 2008. But the growth of PCP means a glut of relatively young used cars will hit the market when those three-year deals expire.

Leech says the price correction could be sudden -- a fall of up to 10 percent in residual values is possible. The average price a used fleet car fetched at auction plunged 19 percent during the financial crisis, according to the BCA Used Car Market Report.

Preserving residual values is hugely important for carmakers, because it determines the cost of leasing vehicles. It also matters to consumers looking at the total cost of ownership as well as dealers who want to avoid their forecourts being stuffed with fast-depreciating assets.

A price correction would squeeze the margins of car finance companies and dealers. Some investors would also be hit because PCP loans have been bundled into asset-backed securities.

Most importantly, a fall in used car values would have an impact on new car sales. Dealers tend to buy out PCPs early in order so customers get a new vehicle. But that incentive would evaporate if residual values fall. Meanwhile, new PCP offerings would have to become more expensive to account for higher depreciation costs.

Add the impact of future interest rate rises and the tendency of city dwellers to abandon ownership for car-sharing, and you have a major threat to sales.

It's possible manufacturers will avoid a pile-up if a prolonged drop in price of fuel encourages more people to buy their own vehicles, and fleet sales are still growing robustly.

But if the U.K. market sours, Europe's carmakers may finally have to face up to the fact they have too much production capacity on the continent. Unlike the U.S. car industry, which underwent a painful restructuring during the great recession, Europe barely closed any plants. This bubble may force their hand.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Bryant in Frankfurt at cbryant32@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net