Previously I analyzed GM's decline and the rise of new firms in the US market. It was simply (but ironically) sound short-run strategy for all involved. Some time soon I extend that, arguing that downsizing in the auto industry presents almost insuperable challenges.
Here I argue that overcapacity and low profitability are intrinsic to the industry. Even if GM shuts down completely, removing a big block of production capacity, the overall impact will be fleeting. When the economy recovers, none of the volume OEMs will roll in profits, even Toyota. At core new entry is simply too easy. For years the new entrants – Detroit South – benefited from a pricing umbrella, as the Detroit Three priced to cover fixed costs. Henceforth, the volume players will have lost that last vestige of pricing power.
Caveats. First, I am less sure that the luxury producers will fall into the same trap; my instinct is they will. Second, this logic is specific to OEMs, not to suppliers or to distribution and finance. Third and finally, I avoid the jargon of a professional economist, but for any fellow members of the secret society of PhDs, this is a standard application of the model of monopolistic competition.
Bear with me while I explain.
Back in the bad old days of the 1960s, developing a new car was a long and costly undertaking, paling in comparison only to that needed to develop a new engine. As traced in Takahiro Fujimoto's Harvard Business School PhD thesis, and summarized in The Machine That Changed the World and elsewhere, firms in Detroit employed a sequential process that began with stylist sketches, then sculpted that into a clay model, and after concept approval moved to hand-crafting prototype parts. Once those checked out firms built tooling, which then was carted to an assembly plant for prototype production. Not everything would go right the first time around, and so some things would get thrown back into the pipeline, delaying the entire process. All in all it took 4 years and frequently more from initial approval to "Job One," ate up capital, and led to lots of incomplete fixes.
Meanwhile the market may have moved on. GM (and Toyota) were thus both explicit about it: if a model sold, tweak it but no more. Besides, with large market shares they had very little upside potential, and if the resulting car was blah, it should still sell OK. (If it was edgy, it could flop, which for a volume vehicle would be a true disaster.) Given all this, a car needed to be kept in production for 4-6 years to pay back up front costs, though perhaps it might be "freshened" midway with minor changes to the body and trim.
Japanese firms had grown up in a different environment: after the initial chaos of multiple firms entering and exiting in the 1950s, some 11 firms remained. Rivalry was thus more intense than in the US (or in Europe), and capital was scarce. A leisurely design process would be a route to failure, between the launch of new models by rivals and the sheer expense of the process. In addition, the same capital constraints (reinforced by the structure of the union movement in Japan) meant a greater role for suppliers in the process. Partly in response, the OEMs used an overlapping rather than a strictly sequential process. For example, you could begin work on structural components as soon as the attachment points of the sheet metal skin were fixed. Forcing cooperation across functions improved intrinsic design quality. But the real bottom line was speed.
During the 1990s such project management techniques diffused throughout the industry. Meanwhile the IT revolution was moving apace as was a revolution in materials science. For the former, CATIA, computer-aided design (CAD) software developed by the French aerospace firm Dassault Systemes, helped set the standard. CAD systems not only saved labor; they saved time while improving accuracy. Designs could be recycled, stretched, modified at the stroke of a light pen, and then sent electronically to suppliers or to a machine tool that could work on a prototype while the engineers slept. Eventually even the prototype was eliminated: structural testing and even mock assemblycould be done in a purely virtual world. Again, the real bottom line was speed.
Speed not only meant it was possible to better match market trends. Speed lowered costs. The "platform" concept pushed things further. Much of the engineering hours went to the brake-suspension-steering assemblies, and the design of the crush zones front and back, and other systems that were to some extent dependent on the size and weight parameters of a design. Once a new model was done, those core systems could be modified to create a whole family of vehicles in that size class, with some assurance that handling and safety performance and cost would be acceptable. That translated into more savings in development time and project cost.
So … in the 1950s there were around only 60 models on the road. There are now 60 new models a year. In extremis, a new vehicle can be designed in under 2 years; routinely, in under 3. Of course international trade complements these changes; it now makes sense to develop vehicles with modest shares in several markets, and a wider global palette of vehicles means a firm may be able to paint in a hole in a market that they would have ignored in the past.
At the project level the logic is inexorable. There are also lots of players. In order of US sales they are (subject at any time to Chapter 11!) the Big Three [GM, Toyota and Ford], the Middle Four [Chrysler, Honda, Nissan and Hyundai] and the ] and the Little Seven [VW, Mazda, BMW, Mercedes, Subaru, Suzuki and Mitsubishi]. And these 14 exclude firms that are solely importers! The chance that a vehicle will prove a hit is slim; the pressure to redesign and attack new segments immense. Almost everyone is optimistic at launch; almost everyone is disappointed. So on average there is everywhere excess capacity; it is better to be able to build more than to be caught short, and you don't want to drop margins. For years sales per model have trended down. And the irony is that while the improved economics of the design process has encouraged more vehicles, the aggregate effect is that overall costs haven't fallen in a commensurate manner; indeed, they may well have risen. And so another bottom line appears: red ink, or at least meager margins.
There is in my mind no way to reverse this process. No firm is large enough to take into account its impact on the overall market from model proliferation. So all continue to throw more models at the consumer. Of course the process built up a head of steam during the Greenspan-Bush Bubble; to date we've not seen many project cancellations. But to repeat, no longer is any single firm large enough in the market to mute the logic of this process.
Again, a bottom line, the bottom line: on a structural basis, an OEM is now and will remain a business that will barely manage a positive return on assets in good times and will bleed badly in poor times. It is a fundamentally bad business to be in and it will not get better, only less bad.
Here I argue that overcapacity and low profitability are intrinsic to the industry. Even if GM shuts down completely, removing a big block of production capacity, the overall impact will be fleeting. When the economy recovers, none of the volume OEMs will roll in profits, even Toyota. At core new entry is simply too easy. For years the new entrants – Detroit South – benefited from a pricing umbrella, as the Detroit Three priced to cover fixed costs. Henceforth, the volume players will have lost that last vestige of pricing power.
Caveats. First, I am less sure that the luxury producers will fall into the same trap; my instinct is they will. Second, this logic is specific to OEMs, not to suppliers or to distribution and finance. Third and finally, I avoid the jargon of a professional economist, but for any fellow members of the secret society of PhDs, this is a standard application of the model of monopolistic competition.
Bear with me while I explain.
Back in the bad old days of the 1960s, developing a new car was a long and costly undertaking, paling in comparison only to that needed to develop a new engine. As traced in Takahiro Fujimoto's Harvard Business School PhD thesis, and summarized in The Machine That Changed the World and elsewhere, firms in Detroit employed a sequential process that began with stylist sketches, then sculpted that into a clay model, and after concept approval moved to hand-crafting prototype parts. Once those checked out firms built tooling, which then was carted to an assembly plant for prototype production. Not everything would go right the first time around, and so some things would get thrown back into the pipeline, delaying the entire process. All in all it took 4 years and frequently more from initial approval to "Job One," ate up capital, and led to lots of incomplete fixes.
Meanwhile the market may have moved on. GM (and Toyota) were thus both explicit about it: if a model sold, tweak it but no more. Besides, with large market shares they had very little upside potential, and if the resulting car was blah, it should still sell OK. (If it was edgy, it could flop, which for a volume vehicle would be a true disaster.) Given all this, a car needed to be kept in production for 4-6 years to pay back up front costs, though perhaps it might be "freshened" midway with minor changes to the body and trim.
Japanese firms had grown up in a different environment: after the initial chaos of multiple firms entering and exiting in the 1950s, some 11 firms remained. Rivalry was thus more intense than in the US (or in Europe), and capital was scarce. A leisurely design process would be a route to failure, between the launch of new models by rivals and the sheer expense of the process. In addition, the same capital constraints (reinforced by the structure of the union movement in Japan) meant a greater role for suppliers in the process. Partly in response, the OEMs used an overlapping rather than a strictly sequential process. For example, you could begin work on structural components as soon as the attachment points of the sheet metal skin were fixed. Forcing cooperation across functions improved intrinsic design quality. But the real bottom line was speed.
During the 1990s such project management techniques diffused throughout the industry. Meanwhile the IT revolution was moving apace as was a revolution in materials science. For the former, CATIA, computer-aided design (CAD) software developed by the French aerospace firm Dassault Systemes, helped set the standard. CAD systems not only saved labor; they saved time while improving accuracy. Designs could be recycled, stretched, modified at the stroke of a light pen, and then sent electronically to suppliers or to a machine tool that could work on a prototype while the engineers slept. Eventually even the prototype was eliminated: structural testing and even mock assemblycould be done in a purely virtual world. Again, the real bottom line was speed.
Speed not only meant it was possible to better match market trends. Speed lowered costs. The "platform" concept pushed things further. Much of the engineering hours went to the brake-suspension-steering assemblies, and the design of the crush zones front and back, and other systems that were to some extent dependent on the size and weight parameters of a design. Once a new model was done, those core systems could be modified to create a whole family of vehicles in that size class, with some assurance that handling and safety performance and cost would be acceptable. That translated into more savings in development time and project cost.
So … in the 1950s there were around only 60 models on the road. There are now 60 new models a year. In extremis, a new vehicle can be designed in under 2 years; routinely, in under 3. Of course international trade complements these changes; it now makes sense to develop vehicles with modest shares in several markets, and a wider global palette of vehicles means a firm may be able to paint in a hole in a market that they would have ignored in the past.
At the project level the logic is inexorable. There are also lots of players. In order of US sales they are (subject at any time to Chapter 11!) the Big Three [GM, Toyota and Ford], the Middle Four [Chrysler, Honda, Nissan and Hyundai] and the ] and the Little Seven [VW, Mazda, BMW, Mercedes, Subaru, Suzuki and Mitsubishi]. And these 14 exclude firms that are solely importers! The chance that a vehicle will prove a hit is slim; the pressure to redesign and attack new segments immense. Almost everyone is optimistic at launch; almost everyone is disappointed. So on average there is everywhere excess capacity; it is better to be able to build more than to be caught short, and you don't want to drop margins. For years sales per model have trended down. And the irony is that while the improved economics of the design process has encouraged more vehicles, the aggregate effect is that overall costs haven't fallen in a commensurate manner; indeed, they may well have risen. And so another bottom line appears: red ink, or at least meager margins.
There is in my mind no way to reverse this process. No firm is large enough to take into account its impact on the overall market from model proliferation. So all continue to throw more models at the consumer. Of course the process built up a head of steam during the Greenspan-Bush Bubble; to date we've not seen many project cancellations. But to repeat, no longer is any single firm large enough in the market to mute the logic of this process.
Again, a bottom line, the bottom line: on a structural basis, an OEM is now and will remain a business that will barely manage a positive return on assets in good times and will bleed badly in poor times. It is a fundamentally bad business to be in and it will not get better, only less bad.
Until the bitter end, Rick Wagoner, deposed CEO of GM, refused to acknowledge bankruptcy as being a viable option for GM. I believe the plan he submitted to the Administration’s Auto Industry Task Force was the best he felt he could do without the benefit of bankruptcy court.
ReplyDeleteBankruptcy court represents handing over control of the process to a bankruptcy judge. The judge has broad powers. A possible “benefit” GM, Chrysler, and the Car Czars might hope to accomplish through bankruptcy is to have all of their franchise agreements with their Dealers rendered null and void.
In theory, this would negate the auto dealer franchise laws in the 50 states. It seems the Administration’s Task Force is determined for GM and Chrysler to shed Dealers. They think there is a cost to an OEM for each Dealer. Nothing could be further from the truth.
But it is probable that GM and Chrysler will be forced to do some things that are ultimately not in their best interest in exchange for “Debtor in Possession” financing required for a Chapter 11 process. The ONLY place DIP financing might be available in the current economic environment is from the government.
Even though I agree the Administration did the right thing when they
"broomed" Wagoner, turned down the deeply flawed GM “recovery plan,” and gave GM an extension, the Car Czars are complete rookies in the auto business. For example, they offer up a government supported plan for warranty coverage to try to get people to continue to buy vehicles from GM and Chrysler. But if there are no parts being produced, and no Dealers left in business, how will this warranty work be accomplished?
The principle issue the Car Czars don’t understand is how the threat of
bankruptcy has caused any GM or Chrysler Dealer with any brains to STOP
ordering vehicles! Rick Wagoner recognized this. In a bankruptcy, the franchise agreement becomes null and void, and along with that goes the OEM’s obligation to buy back new vehicle inventory, parts, and special tools
from their Dealers. Under the franchise agreements, the OEM is even required to buy back the Dealer’s brand signs.
But it is the new vehicle “buy back” provision of the franchise agreement that
allows Dealers to gain bank floor plan financing in the first place. The parts and
tools “buy back” provision provides some security for lenders to extend capital loans. But how many banks will call Dealer "floor plan" loans because there will be no OEM "buy back" provision in place in the case of voided franchise agreements? Losses from this debacle will kill off many Dealers and will take quite a few local banks along at the same time. What might GM and Chrysler new vehicles be worth without a viable OEM?
In Chapter 11, it is not a given that a company will emerge at some point. Many
companies slide from Chapter 11 into liquidation. Without a franchise agreement, the OEM’s technically have no Dealers. Even if they execute some interim contract, if that’s possible under bankruptcy, how will Dealers floor plan inventory? For what amount would banks floor plan them? Why
would lenders want anything to do with it?
I see no evidence that the Car Czars have considered this critical issue, but the fact that Dealers are ordering very little inventory as they wait for the next “shoe to fall” should open their eyes at some point. Despite the fact GM and Chrysler will pay Dealers for vehicle orders, what guarantee exists that says they will be able to collect that “purchase incentive” money as an unsecured creditor in the case of an OEM bankruptcy? And how long would it take to
collect whatever they are allocated by the bankruptcy court?
GM and Chrysler would like their dealers to continue to order right up to, and through bankruptcy. But why wouldn't their Dealers stand pat and work out of each other's inventory to minimize their exposure? A Dealer would have to be in complete denial to still be ordering vehicles from GM and Chrysler. At the very least, his floor plan lender would have to have missed a few key points!
Fritz Henderson has had to acknowledge the bankruptcy possibility and is using it as a bargaining chip as best he can. He desperately needs to get the unions and bondholders to cooperate to achieve the parameters agreed to with the Bush Administration when they took the original money back in December 2008. A major problem is that some of the bondholders have insurance to cover their loss in the case of bankruptcy. This insurance, or AIG type Collateralized Default Obligation, doesn’t pay off if the creditor agrees to a settlement outside of bankruptcy. Why would a bondholder settle for less when they can collect their entire loss in the case of bankruptcy?
GM and Chrysler are already “floating” on their Dealers. Of course, Dealers not ordering cars just hastens the OEMs' journey to bankruptcy court where they will no longer be bound by their franchise agreements, rendering their already strapped Dealers insolvent. What point is there to save GM and Chrysler if there are no Dealers left to sell their products? The Car Czars need to see how the threat of bankruptcy virtually assures bankruptcy.
They need to understand that a so called “surgical pre-packaged” bankruptcy is a disaster waiting to happen. It could cause a ripple effect that could impact South Detroit.
It may already be too late. Resolution on many issues is required before Dealers will feel comfortable ordering inventory and lenders comfortable floor planning them. Since the Dealers are the OEMs’ ONLY customer, the Dealers had better get some answers they can live with soon! A pre-packaged bankruptcy is a joke in the case of either company. In a Chapter 11
all creditors are entitled to be heard. The primary people who benefit are attorneys. The executive retention bonuses and attorney fees granted in a Chapter 11 will raise a “hue and cry” that will ring to the rafters. Without government DIP financing, liquidation is the only option. 5 years is an optimistic projection for a successful Chapter 11 for either GM or Chrysler IF DIP financing is made available. Forget about a 90 or 120 day process.
At some point the Car Czars will see that Dealers have dramatically curtailed their ordering of vehicles because of the floor plan and franchise agreement concerns.
Then perhaps it will dawn on them that, in the face of cheap fuel, consumers are unlikely to pay a technology premium to buy the vehicles the government wants GM and Chrysler to design and build. In the meantime, FIAT isn't going to tolerate any union deals that aren't favorable to their purpose. They have Chrysler by the “short and curlies” with the government deadline hanging over their head. FIAT doesn’t have a lot of cash and would like to get in on the 6 billion the U. S. government has promised Chrysler under certain conditions.
Of course, the Car Czars should scrutinize any deal with FIAT to try to ensure FIAT CEO Marchionne doesn’t try to spirit some U. S. taxpayer money off to Europe! While these tricky negotiations are taking place it’s hard to imagine a Chrysler Dealer ordering anything. This makes it somewhat difficult to put together a business plan based on a “current sales rate.” Things don’t look good for Chrysler and that bodes poorly for GM. The ripple effect of a Chrysler liquidation puts GM, Ford, and some other OEMs in jeopardy.
The government pension guarantee fund would take a huge hit, UAW retirees will get less money than if they agreed to a deal, and that will just be the beginning. We are truly living in historic times.
thanks, david ... I borrowed from this for a later post. mike
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