LEXINGTON [Virginia] When the good news is that Honda's U.S. sales are down only 28 percent and Toyota projects losses of only $5 billion, it's clear the auto industry's problems extend well beyond Detroit. Market pro jections by car companies for 2009 vary by 30 percent, while light truck sales are up -- for now. Which cars will sell is no clearer than how many will sell. Yet, in its December "bailout" to the industry, Congress mandated that Detroit produce turnaround plans by Feb. 17 and show progress in implementing them by March 31, or get thrown into bankruptcy.
The reality is that credible planning is impossible. And in an industry with high fixed costs from parts producers -- which employ three times as many workers as the car companies themselves -- down to dealerships, a 40 percent decline in sales means everyone is losing money. Those without a cash cushion will go under. In the past few months 40 suppliers have declared bankruptcy; hundreds of dealerships have closed their doors. The entire "value chain" of the industry is in parlous health, but is so interconnected that if too many firms fail, the normally orderly process of bankruptcy will spiral into a chaotic shutdown of all manufacturing, taking with it 1 million jobs in short order.
LET'S BE frank: There are no easy solutions. Improved engineering processes allow firms to launch new products more rapidly than ever. A vehicle that sells well soon faces competition from all sides. Even before the recession, chronic excess manufacturing capacity and bloated dealer inventories plagued the industry. One indication was the launch by the Japanese and Germans of SUVs and pickups, which they've found hard to sell. There's been excess capacity across producers and product segments, and not just in Detroit.
Then came the bubble. During the four years leading up to our current downturn, the stock of vehicles expanded by 22 million units, leaving us with 248 million vehicles for 202 million drivers. Now population growth adds 2 million drivers a year, and expanding businesses top that off with another million units of demand. The market might more reasonably have grown by 12 million units -- not by 22 million. The overhang created by the bubble isn't just in housing.
One temptation is to try to pile on government-financed incentives. But as the industry well knows -- and the Detroit Three know better than most -- artificially boosting demand with discounts and sales to rental car fleets carries a steep cost: It "buys" sales from the future and leads to an outpouring of used cars a few years down the road. So purchasers receive poor prices on their trade-ins. That, in turn, leads to a perception that these vehicles are low in quality when, in fact, poor trade-in prices reflect supply-and-demand. Incentives thus come back to bite the industry, but high levels of discounting are addictive, as sales plummet the moment they're removed.
ONE POLICY that might help is a version of "cash for clunkers." This would help eliminate the market overhang created by the bubble to get rid of old cars rather than trying to pile on more new ones. To make sense, however, it must really be targeted at clunkers -- and hence should offer more cash for older vehicles. It might start at $500 for a 10-year-old vehicle, bumping the payment up $100 per year, with $1,500 for vehicles aged 20 and above. The new Department of Transportation vehicle tracking system would help ensure that these vehicles are recycled into scrap, and DOT and the EPA also have the expertise to jiggle the details to get rid of a target number of vehicles (say, 2 million).
This policy would be no panacea; if pursued too aggressively, it could make it harder for lower-income Americans to buy a vehicle. Nor are all old cars inefficient; the subcompacts of the 1980s got tremendous mileage. Owners might prefer to drive such clunkers rather that accept cash. But unlike other proposals, this policy would not distort new car purchasing decisions and would thereby avoid another downturn in sales the moment the program ended. Improve access to finance for credit-worthy borrowers, yes! -- and the recent targeting of TARP funds to the finance arms of General Motors and others has helped. But to offer an alcoholic strong drink -- that is, to pile on more discounts -- not only won't work: It's just plain wrong.
Until I saw the success of the German program I was lukewarm on Cash for Clinkers. I think it will take a lot more than $500. dollars to get consumer attention. After we get dealer floor plan and auto credit and finance under control, we should give it a go. Not everyone would be helped equally, so conservatives might have a problem with it. Then there is the debate about the incentive appplying only to vehicles built in N.A. This would incentivize a lot of vehicles built in Canada and Mexico and give no help to those buying a vehicle of foreign manufacturer, despite the fact that many of those vehicles use a lot of parts from the U.S. For example, I think most or all Lexus leather interiors come from the U.S. Someone straighten me out on this if I'm wrong!
ReplyDeletePlenty of problems with Cash for Clunkers, as we've discussed. I am concerned with what I view as an excessive stock of vehicles built up during the bubble. But it could easily be made too complicated. So (i) don't require that those trading in buy a new car, and (ii) do it on the basis of model year with the price increasing for older vehicles to get the real clunkers gone. That should pull up the long end of the used market, and so flatten the pace at which vehicle prices fall with age. Now that might not feed back up to nearly-new cars immediately, but over time it should facilitate trade-ins and leasing. And I know that latter is a modest interest of yours.
ReplyDeleteRuggles Report March 2009
ReplyDeleteDrop Dead Day
Well, we were ready to go to “press” with a piece on the wholesale market and auctions, when “Drop Dead” day for GM and Chrysler arrived and Rick Wagoner’s head rolled. I have been shocked by the “hue and cry” from so many different angles. So the piece on wholesale will have to wait.
There have been many polls showing auto industry people in favor of Wagoner’s “forced resignation” at the rate of 70%. Some agree with the “forced resignation” but disagree that the Administration should have the power and authority to influence such a decision within a “sovereign” company. This despite the fact the taxpayers own the most senior debt of GM and have been given the authority as a condition for receiving the money in the first place.
Others dismissively want the car companies ushered into bankruptcy court as if that’s an easy thing to do. Those who view bankruptcy as the best option may be correct, and it may come to that. But first a quick review of a recent bankruptcy to provide some perspective.
The Impact of Corporate Chapter 11 Bankruptcy
United Airlines declared Chapter 11 in 2002 and emerged in 2006. An airline and an auto company are two quite different business entities. A comparison of an auto manufacturer and an airline should note the fact that the auto manufacturer depends on a long string of supplier manufacturers. In today’s economic climate, those supplier manufacturers are on thin ice. A Chapter 11 filing by GM would most certainly be followed by Chapter 11 filings and liquidations of an entire string of suppliers.
The Pension Benefit Guaranty Corporation was 23 billion dollars in deficit BEFORE UAL dumped a $9.8 billion default on them. As a practical matter, the “cost” to the government was “only” about $6.6 billion. Many UAL workers in retirement experienced a 50% cut in pension benefits. But let’s focus on the $6.6 billion cost to the PBGC and try to put this in GM terms.
First, a little background: According to a New York Times article in July of 2008, GM’s maintenance of a corporate welfare state became too obvious to ignore. From 1993 – 2007 it spent $103 billion on legacy pensions AND retiree healthcare. What else could it have done with the money had it not obligated itself to “legacy” costs? In the 1990’s, it could have designed new vehicles OR even acquired half of Toyota. It did pay $13 billion in dividends. GM has existed for its retirees, not for its owners.
A GM bankruptcy, either via Chapter 11 or Chapter 7, would create a pension liability of roughly $23 billion dollars. This is IF there are no supplier bankruptcies added to GM’s. This is IF Chrysler and Ford can avoid bankruptcy as well. Imagine all three in Chapter 11 along with a large number of their suppliers.
The Government’s Role
But now GM has a NEW stakeholder. The taxpayers have loaned GM MORE than its current book value, and by a large amount. There were written and agreed to “strings” attached to these loans. It takes political guts for the Obama administration to take a stand that runs counter to the wishes and desires of one of its core constituencies, the UAW. This at the same time the unions’ “Card Check” initiative is foundering and the administration isn’t going out of its way to try to resuscitate it. Yet, some of the current conversation has to do with the audacity that the major stakeholder should have any influence in a company that owes its very existence to that stakeholder.
So why not a Pre-Packaged Bankruptcy (PPB)? A PPB is a plan for financial reorganization that a company prepares in cooperation with its creditors that will take effect once the company enters bankruptcy. This plan must be voted on by shareholders before the company files its petition for bankruptcy, and can result in shorter turnaround times and less cost.
Given the fact that the Administration seems to want the power to trump decades of franchise dealer law in the 50 states, something I strongly disagree with, I don’t see enough critical parties agreeing to a PPB for it to work.
Yet the most obvious reason to avoid PPB is because of uncertainty. It’s never been done before with a corporate entity as large and complex as GM. The chain reaction through the supplier base is also unpredictable. It could even drag Ford down at the same time. Competing with a rival under bankruptcy protection is difficult enough when times are relatively good.
In more certain times, “Debtor in Possession” financing could be obtained through normal channels. In today’s economic and banking climate, the government is the only option to provide this financing.
Let’s review some auto industry suppliers’ names:
Delphi, just sold its brake business to China ·
Visteon, just declared its UK plants insolvent
Johnson Controls ·
Lear, recent "ongoing concern" warning
Arvin Mentor
Federal Mogul, just out of Chapter 11
Goodyear Tire and Rubber ·
Hayes Lemmerz, in reorganization
Tenneco·
TRW ·
Borg Warner·
American Axle
These are only a few - and they are not your local Checker Auto Parts stores. Instead, we are looking at HUGE global companies with tens of thousands of employees, R&D departments, hundreds of millions in sales, and LEGACY COSTS to be dumped on the taxpayers. These companies also have hundreds, if not thousands, of companies who supply them. Some of these companies are deeply involved in aerospace and other critical industries. It is just impossible to predict the consequences of the potential ripple effects throughout industry and the world economy.
This piece is not designed to be a scholarly accounting of all the costs that might fall on the U.S. taxpayer in the event of a Chapter 11 filing. I’ll leave that to economists. The intention here is to give a general idea of how expensive and unpredictable a GM Chapter 11 might be for taxpayers.
In Chapter 11, the media scrutinizes everything. Imagine the “hue and cry” when it is discovered that the BK judge approved hundreds of millions of dollars in attorney fees and granted RETENTION BONUSES to keep critical executives. All of this is why the most knowledgeable people associated with the auto industry understand that there is less risk and less taxpayer exposure with a “bailout” than with a pre-packaged bankruptcy. But GM’s “PLAN” has to make sense.
In the absence of Chapter 11 and without government (taxpayer) “Debtor in Possession” financing, the only other option is liquidation. There is NO EVIDENCE that DIP financing could be made available in today’s economic climate from the usual private sources.
So what would happen under liquidation? I disagree strongly with an economist on CNN last night who stated the auto industry represents 2.8 percent of the total economy and to lose that would be catastrophic.
He failed to acknowledge the fact that sales would be picked up by other manufacturers’ dealers, after a period of intense confusion. BUT chain reaction effects are sometimes hard to predict. I’m not sure our economy needs any more uncertainty than it has. I can imagine the government trying to honor a liquidated auto maker’s product warranties without dealers, technicians, and repair parts.
The Shortcomings of the Rejected GM Plan
Following are the basic criticisms of GM’s survival plan by the auto industry task force and some commentary:
According to Automotive News, the Obama Administration Auto Task Force has 5 distinct complaints with GM’s survival and success plan under the following headings:
1. Market Share Projections
2. Price/Profit Margin
3. Brands/Dealers
4. Product Mix
5. Legacy Liabilities
1. Market Share: GM’s projections were overly optimistic, and by a large margin. At the same time GM stated it would reduce fleet sales, dealers, and entire brands, its market share projection only reflected a market share drop from 21.5% to 19.1% by 2014. They are set to get rid of Hummer, Saab, Saturn, most of Pontiac, plus 2,000 dealers and they only project their market share to drop by 2.4 percent? I wonder why the Administration didn’t go for that?
2. Price: GM’s pricing and per vehicle profit projections were wildly optimistic. GM’s assumptions were that the incentives required to move vehicles would decline, leaving them with higher margins. The administration did not go for this one either.
3. Brands/Dealers: “GM is currently burdened with under performing brands, nameplates and an excess of dealers,” the task force said. GM said it plans to offer just four core brands -- Chevrolet, Cadillac, Buick and GMC --and a cut-down version of Pontiac. It also said it would reduce its dealer count from 6,246 in 2008 to 4,100 in 2014. The task force said those measures are not aggressive enough.”
I’m OK with the part about under performing brands and nameplates. I just don't understand the part about too many dealers. (See last month’s Ruggles Report) This is where I have a MAJOR BREAK with the Administration! When they reduce the number of dealers, GM absolutely gives up sales AND market share, which relates back to the first issue of optimistic market share projections. I understand that it’s not all about market share if you have to lose money on each unit of sales to achieve that share. But the only way they could shed dealers would be through Chapter 11, and that would drag on for YEARS! And it would be totally counter productive.
4. Product mix: According to the Administration, GM is still too dependent on Trucks and SUVs. The VOLT will carry a $40,000. price tag. After the “Greenies” and the “Be the First on the Block” crowds, who will pay this kind of technology premium in the face of $2.00 fuel? “Where are the fuel efficient products for consumer’s to buy today?” asks the Administration. GM has them, but until they rein in their cost structure, they aren’t profitable enough to sustain the company in the current economic climate.
5. Legacy liabilities: If you have read this far, you have already encountered our commentary on pension funds and how a bankruptcy would inject some very negative “knowns” and “unknowns” into the equation.
”To reach its pension obligations without substantial changes would require GM to sell 900,000 vehicles per year just to cover these obligations,” according to the task force. That would leave GM in the familiar position of being a company that exists for its retirees, rather than for its owners. “That would leave GM fighting to maximize volume rather than return on investment," the task force said.
Because of the action of the Administration, I hope the bondholders AND unions will be forced to take stock in lieu of other obligations, rather than GM seeking Chapter 11! It is better than what they would receive in either form of bankruptcy. And there is considerable upside to it! Trading stock for debt will address 4 of the 5 major issues the Administration has with the rejected GM plan. If GM’s cost per vehicle is much lower, they can use more realistic and conservative market share projections. They wouldn’t be so vulnerable to the financial impact of the aggressive incentives that might be required to move iron in a weak economy. It would free up capital for investment in new products. It would make GM’s survival and success less dependent on people paying a technology premium for vehicles like VOLT and their new HYBRID products. BUT I’m still stuck on this idea of getting rid of 2,000 Dealers.
Learning From History
I lived through the Chrysler bailout of the Carter years. Shortly after his inauguration Reagan didn’t endear himself to Lee Iacocca when he made the comment, “You’re lucky I wasn’t in office when you came for money or you wouldn’t be here today!” It was with great pleasure that Chrysler and Iacocca paid off their loan guaranties early and with proper interest. No one expected this to happen so Chrysler had neglected to negoiate a pre-payment interest credit. It was so important for Lee and the boys to “stick it” to Reagan they paid the loans off early anyway! These are different times but there are some similar circumstances.
In the eighties, Chrysler had to liquidate its private planes and tolerate a high level of scrutiny. The deal was loan guarantees, and Chrysler had to deal with a multitude of banks. Every "I" and "T" had to be dotted.
Chrysler was floating on it's dealers and we all knew it. We'd talk to the factory guys about it. They'd ask us not to complain to the Feds and maybe the Feds wouldn't notice.
Events were on the news every night. Without the media fragmentation that exists today everyone who was watching TV, or reading the papers, was seeing the same thing.
At the same time we had double digit inflation AND 20 percent floor planning AND no sales. Today we have CHEAP interest and virtually zero inflation. I had 3 floor plan banks in 20 months without having to resort to Chrysler Credit, which was "limited repurchase" at the time. We were fortunate to have been so profitable at the time that banks would even talk to us.
I was interviewed on national TV every month for over a year. They'd come to the Dealership in Evanston Illinois, an immediate Chicago suburb, with the complete camera crew to do the deal.
All Dealers’ books were bogus to a degree. Our receivables were overstated. No one would have paid "book value " for them. Warranty, holdback, and incentive receivables from Chrysler? Are you kidding? Mark to market? We would all have been “dead meat.”
Facilities weren’t worth what was owed on them. Most facilities were owned by ABKO Properties, a real estate company from Wichita, as Chrysler was forced to “cheap sell” these facilities to raise cash. ABKO was a joint venture between entrepreneur George Ablah and Wichita-based Koch Industries formed specifically to purchase Chrysler Realty Corporation in the late 1970s from a hard-pressed Lee Iacocca. Fixed assets were over stated based on the current market conditions.
It was a huge house of cards that managed to stay intact, largely because of the personality and leadership of one man! His ability to bullshit and obfuscate should not be underestimated. He could look you in the eye and lie to you... you knew he was lying... he knew that you knew he was lying. You knew that he knew that you knew he was lying.... he made you not care and do what he wanted anyway.
At some point, people bought Chryslers in support of American business and in support of the “under dog.” They were such lousy vehicles in those days. The warranty costs on them were terrible, BUT the dealers got paid for fixing them, eventually. Many consumers just looked the other way.
There were a lot of behind the scenes activities to urge municipalities and states to buy Chrysler squad cars. Pressure was put on fleets buyers to buy Chrysler products. Some pressure came from bankers who had skin in the game. Some came from the Government behind the scenes.
The K car provided cover for Chrysler to buy time, in hopes of the loan guarantees AND a return of the market. Chrysler had been highly criticized for depending on “gas guzzlers.” When the first K cars were shipped to dealers, they had only built fully loaded ones in their search for gross profit dollars.
The cars were terrible. The engines were rough and dashboards rattled and buzzed. The steering wheel would put your hands to sleep from the vibration. The MSRP was over 10K, and this was in 1980 for a 4 cylinder car.
In my view, the money made on each K car in the beginning wasn’t enough to make much headway. The real monetary progress came when the public started buying redone Volares called New Yorker Fifth Avenues, Cordobas, Furies, Dodge Trucks, etc. Iacocca had parlayed the prospect of the K car into enough time to bridge the company to a return to the market that existed before the fuel price spike that set the whole thing off in the first place.
In time, the K car evolved into some decent machinery including LeBarons, minivans, etc. Chrysler made enough money to buy Jeep, and the rest is history.
The pressure exerted by the government as a condition for the loan guarantees enabled Chrysler to exact concessions from stakeholders to reduce their costs.
Wrapping It All Up
Imagine the impact on GM if they are able to reach major concessions with the UAW and bondholders, dramatically reducing their costs. And at the same time, the market comes back on SUVs and Trucks while fuel stays cheap. I’m not predicting that! But there is a lot less uncertainty in a “bailout,” IF certain important cost saving targets can be reached, than with a PPB.
But Chapter 11 looms around the corner for GM! And for better or worse, the primary stakeholder is calling all the shots!