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Tuesday, April 28, 2009

Follow the Money

The news today is of efforts to cut the cost side of the OEMs, Chrysler of course but also General Motors. Is this good news? To frame that question we need to do two things. First, what of the revenue side? Second, what of the overall value stream? – after all, the OEM slice is a quarter or less of total, not including the aftermarket, consumer finance and so on. The way I read it, we do not yet have any good news, because focusing on costs while revenues slide is chasing a will-o'-the-wisp. And the upstream and downstream segments are on the brink of a deep precipice – but I'm not sure which side of the brink.

To my mind, the key variable at the moment is the residual (resale) value of a vehicle. As long as it remains low, it cuts into the arteries, and staunching the bleeding is hard. A low residual value means that purchasers are more likely to be "under water" on their current vehicle, with a trade-in value less than their loan balance. A low residual value means that leasing is dead, and a straight loan has to be priced higher, to cover the poor value of a vehicle as collateral (never mind the current recession-driven risk that the borrower's income may disappear). And a low residual value means that even if the buyer will pay cash (or has equity in their current car), they will shy away from a great vehicle in favor of one that because of its nameplate will hold its resale value. [I will post this before digging up sample numbers, say of a Toyota Titan and a comparable GM pickup – comments, please!] If the 4-year-out resale value of one vehicle is 50% of purchase price, and of another is 30% – well, no OEM can afford to discount their vehicles up front enough to offset the different.

So how to pull up residuals? Unfortunately the cutback in fleet sales at GM is too recent to have cut the flood of used cars that has depressed their residuals over the past several years. [Or so I assume -- ADESA or various used car guides could provide data.] In a year or two the impact would have been tremendous, had the recession not intervened. After all, GM has the car of the year and good ranking in the JDPowers quality surveys. (Ditto the combination of VEBA and retirees hitting age 65 to handle legacy costs on the cost side come 2011.) But luck was not with them. Maybe the biggest help the government could give is using its purchasing dollars not on new vehicles but on 2-, 3- and 4-year old vehicles to pull up their resale value.

Low residuals hurt other portions of the industry. If a dealer closes its doors, the normal franchise agreement obligates the OEM to repurchase inventory at cost. For the bank that finances this inventory ("floorplan") that is crucial. No bank is prepared to accept 200 cars on a lot when a loan forecloses. But if GM faces Chapter 11, it would no longer be obligated to make dealers (or their lenders) whole. Now if the residual value of GM vehicles was high, lenders could at least figure out what such collateral would be worth. As it is, no lender in their right mind would extend additional financing to a GM dealer (much less a Chrysler dealer). And no dealer would order a new car. That means that these companies will have zero revenue, because even if consumers flock to dealership lots, GM sells cars to dealers, not consumers.

That's of course the downstream viability story: GM may not have any dealers left, due to the collapse of financing, and they certainly won't have dealers buying cars. Costs cuts can never offset such revenue cuts. Of course if GM goes, and there is a massive firesale, Honda and others will face crisis, too, because consumers will have the choice of a new GM vehicle at 50% off – who knows? – and why in such a situation would you buy a used Honda? or a new one?

Now the upstream parts sector is in as bad of shape, maybe worse. While GM is closed they will be ordering no parts (remember that the factories of parts firms employ about 3x the number of manufacturing jobs at GM and its peers). With no orders, no revenue. Now the strategic imperative for suppliers the past decade was to diversify their customer base. But how can they keep their factories open if Honda and Toyota are 25% of their revenue, and GM and Chrysler 75%? And how can they fund the engineering effort on new vehicle models and basic R&D needed to garner orders for vehicles launched in 2012 and 2013, when sales will hopefully have rebounded? I don't think they can. My own feeling is that the downward spiral is not letting up. The tide is still building, and the whirlpool is getting harder to escape.

So, even if a bailout is arranged that temporarily keeps GM out of bankruptcy, if the downstream and upstream both collapse, well. I want to avoid thinking about what that might look like, and how the industry could start up again. But my quick attempt to follow the money suggests it's flowing down the drain, and the flow is slowing to boot.

thanks to DR and JJH and TK for stimulation

I will try to add numbers later