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Tuesday, February 21, 2017

Peak Auto (I): Frivolous Investments Rise

Mike Smitka, Prof of Economics
Washington and Lee University
Co-author The Global Auto Industry: Innovation and Dynamics, 2017.

The auto industry is at peak. The best indicator lies not in the sales numbers, but in the behavior of the OEMs. Flush with cash, they are again buying businesses peripheral to their core operations, such as ride sharing services.

...car companies frittering away cash is the best indication of peak auto...

OEMs are fixed-cost businesses. The design and engineering of cars and engines chews up piles of cash. Assembly plants need someone at every work station, whether they are are busy making cars, or merely trying to look busy. Workers on the line thus are likewise a fixed cost. So when sales plummet, companies bleed red ink. Likewise when sales are strong, car companies spin off incredible amounts of cash.

The problem at the peak of a cycle is what to do with all that money. Executives know that they ought to save it for the inevitable rainy day, but as publicly traded companies they find that hard to do. Instead they buy things. In previous up cycles the Detroit Three all acquired aerospace firms – for GM it was Hughes Aircraft. They built new R&D centers, such as FCA's [Chrysler's] showcase Auburn Hills (Michigan) complex. They purchased banks. They got into the rental car business – Hertz was Ford's play in that footprint. They added brands, too, from Hummer and Saab to Ford's Premier Automotive Group that included Volvo, Jaguar and others.

Europe and Japan are no different. Under Jürgen Schrempp Daimler accumulated a wide array of businesses, in aerospace, heavy trucks, and mass-market cars [Chrysler and Mitsubishi Motors]. VW stuck mainly to motor vehicles, but they also got into the heavy truck industry, and picked up smaller companies such as SEAT and Škoda and superluxury marques including Lamborghini and Bentley (at the time VW wrongly thought they were getting the Rolls-Royce brand as part of the deal, in a hasty deal emblematic of "peak auto.") In Japan less money went into unrelated businesses, though Toyota builds houses and boats. Instead they proliferated models and brands. For example, Mitsubishi Motors and Mazda, the smallest of Japan's Big Five, both added multiple marques ("channels" in Japanese parlance) in the 1980s; MMC's Diamante luxury marque lasted a little over a dozen years, consuming resources their core products and dealers sorely needed.

Car companies likewise forget their rental car company history to their detriment. They were never good at fleet operations, which involve running branches at airports and in cities small and large, all while balancing fleet size over the course of a year, and carefully watching acquisition price versus the residual wholesale auction value as a used car some months later. That's a very different set of skills than those needed to design, manufacturer and sell vehicles over the four- to six-year-long cycle of a full model change at an OEM.

At one time Ford owned Hertz, Chrysler had Dollar Thrifty, General Motors held a stake in Avis, and first Renault and then VW controlled Europcar. In Japan dealership channels have captive rental operations, but the market however is dominated by Nippon Rent-a-Car and Orix, owned respectively by an airline and a leasing company. In Japan, Europe and the US the car rental industry has consolidated into fewer players, including in the US the acquisition of Budget/Thrifty by Enterprise.

Car companies came to realize that for a rental agency to make money, they had to buy base models at wholesale prices. Having a captive rental firm as a customer thus tended to depress, not raise, OEM margins. While in the short run car companies could push vehicles into rental fleets to keep factories running, that led to operating losses at the rental car companies. It wasn't hard to see through that game, even if the details could be buried in financial statements. Furthermore, rental fleets hold cars for less than a year, so in short order pushing fleet sales depressed used car prices and ate into retail margins. Over time all who have tried have retreated from that business.

So why has GM spent $500 million on Lyft? That have no need to do that to sell vehicles, even if (contrary to current experience) "New Mobility" businesses become significant purchasers of new vehicles. After all, GM can already sell all the vehicles they want to Enterprise, which is the world's largest single purchaser of cars, to the tune of over 1 million units a year. (To GM's credit, they've avoided boosting market share by selling discount vehicles to Enterprise and their peers.)

Ride hailing services are fundamentally fleet businesses. Now Uber, Lyft and others have found creative ways to arbitrage the rules that gave cab companies local monopolies. (Zipcar and Autolib' are different: they operate in urban center rental car niches that were not well serviced by Enterprise and other traditional providers.) To maintain the superior level of performance they promise, Uber for example needs to have lots of cars on the road, with drivers for each. In other words, they will increasingly come to operate their own fleet of vehicles, directly or indirectly, however much they claim to be unlike traditional taxi companies and car rental firms. It's certainly not a business car companies need to be in.

Such uses of cash thus reflect typical "peak auto" behavior. It's a silly investment strategy. Today high tech stocks are pricey, while the need to unload will be greatest in a recession when such assets won't fetch much. GM will get dimes on the dollar. While that's better than having no cash at all, GM's balance sheet isn't like it was in 2007. A recession won't push them into junk bond territory.

...it's sad that simply holding cash isn't viewed as an option...

What we are seeing is thus an old story, money burning holes in pockets. Balance sheets are flush, and CEOs won't catch flack from their boards for buying into the "sharing" economy and the push to make autonomous vehicles. Indeed, executives likely face pressure from their Boards to get into these trendy businesses. It's sad that simply holding cash isn't viewed as an option.

The typical way to assessing peak auto looks to sales trends. Now with sales at a rate of 17+ million units there's scant room for an uptick in volume or profits in North America. There's margin compression in China. The volume vehicle segment in Japan is so perennially unprofitable that Ford has closed their operations, while GM believes Europe is similar and so are selling their (unprofitable) European operations, once the continent's largest. Reading those tea leaves likewise suggests we're at a peak. To me, though, car companies frittering away cash is the best indicator.