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Tuesday, November 11, 2008

An Automotive Hail Mary

On November 7, General Motors and Ford announced stunning losses for the third quarter of 2008 totaling $7.18 billion. News of tightening in the consumer credit markets for the past several months didn't make the sales dip much of a surprise. The more worrisome news from both makers was the staggering amount of cash burned during the quarter -- roughly $14.6 billion between the two. (#1) The quarterly results triggered renewed discussions about the merits of a bailout of the American auto makers by the Federal Government and (hence) American taxpayers.

If Americans needed any reminder of how expensive and potentially futile such bailouts might prove to be, they got it -- the very next business day. On November 10, AIG requested and received a $25 billion dollar nightcap on top of a $37.8 billion dollar refresher granted October 8 on top of a $85 billion dollar initial bailout granted September 16. After nearly $150 billion granted, there is zero concrete proof the money granted to AIG will change the final outcome. That should give pause for elected officials and Treasury officials considering solutions for the auto industry.

A review of the economic footprint of the auto industry is sobering and makes it obvious that a lengthy or permanent decline in sales will produce great economic problems in the larger economy. However, a review of the operations of the firms involved also makes it clear they face issues with management inertia and other intangibles that make it doubtful any road to recovery exists for these firms in their current form and size.

First, Some Statistics

Because every major auto manufacturer operates and sells in nearly every market, trying to correlate sales per company per country with production per company per country and costs can prove confusing. However, it's still useful to summarize some key statistics.

Auto Production by Country for 2007 (see #2):
Japan = 11.59 million
United States = 10.78 million
China = 8.82 million
Germany = 6.21 million
South Korea = 4.09 million
France = 3.02 million
Others = 27.39 million
TOTAL = 71.9 million

Auto Production by Manufacturer for 2007 (see #2):
Toyota = 9.50 million
GM = 9.35 million (13.2% of world total)
Volkswagen = 6.35 million
Ford = 6.25 million (8.69% of world total)
Honda = 3.91 million
PSA (Peugot) = 3.46 million
Nissan = 3.43 million
Chrysler = 2.54 million (3.53% of world total -- ***)
Others = 27.11 million
TOTAL = 71.9 million

*** four makers ahead of Chrysler omitted here for brevity

Total US sales for October 2008 across all makes plummeted 32 percent to 838,156 vehicles (#3). Sales across all of the major makers plummeted in October of 2008. players have been falling in August and September compared to 2007 results for the same months. For GM, August sales dropped 15.6 percent, September sales dropped 20.7 percent, and October dropped 45 percent.

Some other possibly interesting statistics from the "Auto Alliance", a PR media consortium sponsored by virtually all worldwide automakers doing business in the United States (#4):

* Autos account for $690 billion of U.S. retail sales, or about 20% of US retail sales
* Auto sales produce roughly $10 billion in local / state sales tax revenues
* Auto-related production accounts for roughly 4% of United States GDP, or about $554 billion
* total "auto related" jobs are 13 million (10% of non-farm employment)

Per news stories on 2007 UAW contract settlements, employment in the US and Canada for parts and assembly work amounts to 70,000 for GM, 55,000 for Ford and 45,000 for Chrysler.

The Demand Side of the Equation

One concern about a potential bankruptcy of GM is that it is such a large consumer of parts from domestic companies that if it goes bankrupt, those firms will not be able to survive on the remaining demand for parts. Concern over this second-order effect of a GM failure is valid but requires some analysis. For this concern to be strictly true, this second-order affect assumes a GM bankruptcy means:

1) 9.35 million new vehicles stop getting built -- IMMEDIATELY
2) demand for spare parts of existing GM vehicles vanishes - IMMEDIATELY

If point #1 became true in a literal sense, it would mean worldwide demand for cars and trucks would immediately drop by 9.35 million. Auto demand has already dropped precipitously so another drop of 9.35 million in demand certainly isn't out of the question. However, the current climate isn't a reflection that the world market doesn't want ANY of the 9.35 million vehicles, just that SOME of those cars aren’t desired (for price or fuel economy) or that SOME potential buyers can't get credit to buy them. Because of the residual demand for SOME cars, a bankruptcy filing by GM isn't likely to completely shutter the company but is instead more likely to result in additional production cuts of 20-40 percent. That's a huge hit to overall economic activity but far different than a 100% reduction.

If scenario #1 does come to pass, one also has to doubt the likelihood of scenario #2. If demand for new cars drops by 9.35 million, existing owners will be doing without a new car by driving existing cars longer. That will INCREASE demand for spare parts for the existing fleet on the road which is likely 35 percent GM made.

A more subtle point about scenario #2 should also be made. If demand for spare parts for existing GM vehicles also vanishes in a short period of time, the only viable explanation would be that the cars aren't being driven at all, which means consumers will have found ways to reduce miles driven. If that's the case, that's not an argument for trying to prop up what's left of the current domestic auto industry at its current scale. Any effort to do so will simply subsidize designs and manufacturing skills for products that consumers have left behind and no longer want.

For a firm like GM, the analysis has to focus on where demand drops are likely to occur first: profitable gas guzzlers that remain affordable to those less dependent on credit -- OR -- low margin, entry-level fuel efficient vehicles demanded by less affluent customers more in need of credit? The reality is that either answer may not help any automaker who is only profitable making gas guzzlers. More will be discussed of this dilemma under the Supply Side heading below.

In reality, scenario #2 -- a complete evaporation of demand for GM parts -- is highly unlikely. Due to credit restrictions and the need for people to keep older cars longer, demand for spare parts for 10 years of GM products will continue nearly unabated for some time, giving parts manufacturers some recovery time.

The Supply Side of the Equation

Take a look at these figures culled from GM's 3Q2008 report (#5):

3Q2007 3Q2008 change
North American Production 1,020,000 915,000 -10.3 percent
Worldwide Production 2,156,000 2,039,000 -5.4 percent

North American Deliveries 1,206,000 978,000 -18.9 percent
Worldwide Deliveries 2,388,000 2,115,000 -11.4 percent

North American Utilization 84.5% 78.8%

The production versus delivery numbers above point out that GM has succeeded in cutting the growth in excess inventory (deliveries over production is dropping) but a drop from 186,000 sales from inventory in 3Q2007 to 63,000 sales from inventory in 3Q2008 still means they are producing far more cars than dictated by demand. Though worldwide utilization figures weren't provided, the North American number alone is scary enough --- a 78.8 percent utilization rate means GM's yearly total North American capacity is 4.64 million vehicles but if the 3Q2008 trend continues, current demand will only be 3.91 million vehicles for an excess of 730,000 vehicles. It's likely things will get worse before they get better if they get better at all which means GM is operating with nearly 33% excess capacity just for North America. Worldwide excess capacity may be even greater (and more damaging).

Management Strategy and Inertia

For such a capital intensive business, excess capacity implies problems far beyond imbalances between final assembly capacity and demand. In the case of GM, continuing to operate Saturn, Chevrolet, Buick, Pontiac, Cadillac, GMC, Saab and Hummer means it is continuing to dilute any focus on meaningful product redesign and quality for its suppliers and its own final assembly plants. If the company was firing on all cylinders, maybe they could make a case for "focusing their efforts across the board." When the firm is burning $6.9 billion in cash per quarter, it really needs to review every dime of capital spending.

So what projects have been absorbing GM's R&D dollars for the past few years as it lost BILLIONS of dollars and headed into this perfect storm?

* a special edition 2009 Corvette with a 650 hp V8 engine and a $103,000 price tag
* a January 2009 roll-out of a relaunched Camaro with a 300 hp V6 or 422 hp V8

Does anyone have any theories on lessons from building a new generation 650 hp V8 that can be applied to creating a $15,000 entry level car? Does anyone have any idea how much it costs to tool a plant to make an engine for only 5000 units? Does anyone want to venture how many teenagers are going to be able to afford a 300 hp Camaro or the insurance on a 300 hp Camaro when their parents are unemployed?

Rumors also abound of what has NOT been absorbing R&D dollars at GM:

* development of the Cruze sedan slated to replace the Malibu may be on hold (#6)
* redesign of full size trucks and SUVs was deferred as of June 2008

It's not clear if the truck and SUV redesigns were normal restyling or actual attempts at improving efficiency.

The return of $60/barrel oil may only last 3-4 years if economic recovery resurrects worldwide demand or if peak oil theories about supplies hold true. That's not enough time for a complete revamping of product design teams, engine and power train designs and assembly plants to eliminate the gross inefficiencies that GM, Ford and Chrysler have in their current product lines. Typical product development cycles for a significantly new vehicle might be 4-5 years. The current product plans at GM are telling --- and damning -- of its management team. The "car guys" running GM may know cars but they really don't know the car business. They have demonstrated zero insight into where the world markets are headed nor have they demonstrated any understanding of their competitive position. They have laid absolutely ZERO groundwork for new products which can be profitable with gas at $3.00 to $4.00 per gallon.

Considering the Intangibles

If GM and the other American automakers were only facing a credit crunch, overcapacity problems and outdated / obsolete product designs, those problems would be more than enough. The American firms also face key intangible, but equally daunting, problems.

For nearly twenty years, consumer research and quality studies have been published confirming American automakers closed the quality gap with Japanese brands and are producing equally high-quality vehicles. Those reports may be true and won't be argued here. What is worth mentioning is that consumers who bought the junk produced by GM, Ford and Chrysler in the 70s and 80s have very long memories. It's safe to assume that those who resolved to never buy American again will stick to that resolution until they have a worse experience with an "import" than they remember having with an American car.

It's also safe to assume that most buyers are aware that a large portion of units from Toyota, Honda, Nissan, BMW, etc. are made in America and have significant American parts content. Buyers are also likely aware "American" car companies have numerous parts and assembly plants in Canada and Mexico so "buying American" is a slogan, not a reality for any make or model.

The Opportunity Cost of an Automotive Bailout

Estimates of the cost of a bailout of the auto industry have ranged from $25 to $50 billion dollars. Little has been said about whether an attempt would be made to spread those dollars across GM, Ford and Chrysler or if those with a vote have already decided Chrysler isn't worth saving. What hasn't been discussed much yet is the opportunity cost of any bailout attempt.

The opportunity cost of a economic choice is the value of the next best alternative that wasn't chosen. If you have a choice between working overtime for six hours on Saturday for $50.00/hour or playing a round of golf for free and you choose the golf, that round of golf wasn't "free". In economic terms, the opportunity cost of that round of golf was $300 because choosing to play required you to surrender the opportunity to earn $300 in the same time doing something else.

The cost of an automotive bailout is extremely difficult to determine because not only are the alternatives to a bailout difficult to formulate but because it isn't at all clear if a bailout can actually produce its intended effect. The chance of success isn't clear because no one has attempted to clearly state the goal. Is the goal to

1) return the current industry at its current size to profitability with current products?
2) return the current industry at its current size to profitability with new "cars of the future"?
3) provide a smoother path to a downsized industry trying to profit from current products?
4) provide a smoother path to a downsized industry trying to profit from new "cars of the future"

The likelihood of continued tight consumer credit makes any plan aimed at sustaining an industry producing current volumes of cars seem unlikely, making scenarios #1 and #2 highly unlikely. The long term pressure on petroleum supplies and resulting higher prices means cars that perform like today's average cars have little future, making scenarios #1 and #3 unlikely to succeed.

The key variable left is the "car of the future" wildcard.

Any solution considered for the auto industry has to contribute in a concrete way to enabling technologies for more efficient transportation to be developed -- whether that comes in the form of ultra-efficient personal transportation or renewed investment in public transportation.

Go back and read the section on management strategy and inertia then carefully consider one question:

Have General Motors, Ford or Chrysler demonstrated ANY knack for identifying, developing and operationalizing technologies that amount to quantum improvements in vehicles?

The United States and the world at large desperately need two things right now --- a huge economic stimulus to slow down the reduction of jobs and a quantum leap in highly efficient, profitable transportation technology. Solving only one of the two just defers a larger economic contraction by possibly 5-8 years. The bet we make on technology right now HAS to be correct. So are GM, Ford and Chrysler really the receivers we want to send downfield for this Hail Mary pass?

* the same companies that brought us the Corvair?
* the same companies that brought us exploding "side saddle" gas tank in trucks?
* the same companies that brought us exploding Pintos?
* the same companies that brought us the X-cars?
* the same companies that brought us the Fiero Flambe?
* the same companies that brought us unstable Explorers with tread-separation prone tires?
* the same companies that resisted adding air bags for 20 years as too expensive?

The answer to the Hail Mary question really answers the job protection question. If consumers have little faith that the existing incarnations of GM, Ford and Chrysler have any chance of inventing the next generation vehicles we need, their sales will continue to collapse, making it pointless to continue paying people to make vehicles no one wants to buy or no one can afford. The design talent and manufacturing expertise needed for the car of the future may very well be trapped somewhere inside those firms but it seems clear the current management of these firms has no demonstrated ability to lead the charge.

Even if the companies manage to sustain current sales levels, they still have far too much current capacity -- GM needs to cut capacity by nearly 33 percent per the analysis earlier. More large job cuts ARE coming and GM can choose between cheaper Canadian and Mexican plants to meet North American demand. For the jobs remaining, it is VERY likely the companies will use bankruptcy to break collective bargaining agreements and shed pension obligations to reduce wage rates far below current averages.

Different people will come out on different sides of the auto bailout issue but there is one thing probably no one disagrees about. The cost of getting this decision wrong is unimaginably high.


#1) http://www.reuters.com/article/asiaDealsNews/idUSTRE4A52V020081107

#2) http://en.wikipedia.org/wiki/Automotive_industry

#3) http://www.autoalliance.org/index.cfm?objectid=abbreviated

#4) http://ap.google.com/article/ALeqM5gsz39lpYrNG7OiKs3FJt6jhV6NEwD947OQ1G0

#5) http://media.corporate-ir.net/media_files/misc/Q3_2008_Highlights.pdf

#6) http://www.businessweek.com/lifestyle/content/oct2008/bw20081023_883385.htm