From the August 2007 issue of Research Magazine • Subscribe!

August 1, 2007

What's Good for General Motors

When Chrysler, the No. 3 Detroit automaker, was teetering on the brink of bankruptcy in 1979, the Carter administration stepped in with $1.2 billion in loan guarantees that bailed out the company and helped it return to profit. Chrysler repaid the loans four years later.

Since then, like a yo-yo, Chrysler has gone repeatedly from success story to goat and back again. Recently, it carried its German parent through a difficult patch mid-decade before falling on bad times now. Exasperated, Daimler sold an 80 percent stake in the company to Cerberus Capital Management, a private equity fund. The price paid, $7.4 billion, was about 40 percent of what those loan guarantees were worth in today's dollars.

Curiously, this up-and-down pattern has characterized most global automakers for years. Nissan had a near-death experience in the second half of the 1990s, only to be rescued by Brazilian-born naturalized Frenchman Carlos Ghosn, then relegated to Japan's No. 3 automaker by its business partner, France's Renault.

But once Ghosn the Savior became the head of both companies in 2005, they went into sharp decline, as their market share and profitability dwindled. Meanwhile, Italy's Fiat, long believed to be on its deathbed, enjoyed a miraculous revival. The same may be happening to General Motors. The Detroit giant may no longer be the world's No. 1 automaker by volume, having been passed by Toyota this year, but at least it no longer hemorrhages red ink. Its stock price, after plunging to its lowest level in nearly a quarter of a century, nearly doubled over the past 18 months.

Demand ParadoxCountries around the world that currently enjoy the fastest economic growth also have far lower private car ownership rates on a per capita basis than mature economies in North America and Western Europe. But they are catching up fast. China came out of nowhere to become the world's second largest automotive market after the United States. Russia and India have become car-crazy, too, and all of Latin America has been a consistently strong market for global automotive companies in recent years.

This suggests, on paper, strong demand growth for motor vehicles going forward. However, the auto industry is suffering from a structural overcapacity problem. It is perhaps currently most acute in the United States, where plants are being closed and production line jobs eliminated rapidly, but it has been seen in Western Europe as well. In one form or another, excess capacity plagues most automakers.

In this respect, the automotive industry is quite typical of other goods-producing industries. Like other goods producers, automakers are constrained to go into two opposing directions -- either competing on price, engaging in relentless cost cutting and contenting themselves with paper-thin profit margins, or going for the high end, where brand positioning, quality, innovation, design and snob appeal play a crucial role.

Renault-Nissan opted for the former option. Ghosn proudly wears the nickname "Le Cost-Cutter," after he nursed Nissan back to health by relentlessly slashing and then jealously watching its costs. But sooner or later this strategy becomes a race for the bottom. Korea's Hyundai can do pretty much everything Nissan can do, only cheaper -- the advantage that catapulted it into the sixth spot globally among car makers, despite a small domestic market and the fact that it didn't begin exporting cars until 1976.

But with Chinese and, soon, Indian automakers coming into the picture, Hyundai's position is vulnerable. Even mighty Toyota, despite reaping monstrous profits, is starting to see its drive for world domination fray around the edges.

While the luxury end has been doing much better -- along with luxury segments of other goods and services -- driving strong profits at Porsche and BMW, for instance, this end may now also start to suffer from overcrowding and commoditization, now that Daimler is getting its act into gear and Japanese carmakers are marketing Acura, Infiniti and Lexus globally.

Political IssueBut the auto industry is not just another run-of-the-mill manufacturing industry. Gone are the days, of course, when a GM chairman could declare: "What's good for GM is good for the United States of America." The auto industry makes up 4 percent of U.S. GDP and just 10 percent of American manufacturing. All of manufacturing now accounts for 10 percent of U.S. jobs, down from 14 percent a decade ago.

Nevertheless, in world capitals the auto industry wields political power that is well out of proportion to its weight. The government of Malaysia may be unique in recent history in promoting the creation of a domestic auto industry, but the memory of a time when the ability to build a motor car was a gauge of a country's economic prowess lingers in the minds of politicians. Detroit automakers succeeded in the 1980s to impose "voluntary" quotas on Japanese car exporters and more recently they have been frustrating the introduction of more stringent mileage requirements in Washington.

Protectionism plays an important role in why foreign automakers continue to build plants in the United States and run high-cost operations in Western Europe.

Most investors have forgotten the Chrysler bailout, but not the smart money. This is why hedge funds and private equity funds have been so active in the automotive industry. In addition to buying a majority stake in Chrysler, private capital has heavily invested into such bankrupt or nearly bankrupt U.S. automotive parts suppliers as Delphi and Visteon, spin-offs of GM and Ford, respectively.

Other Chapter 11-ridden parts companies have seen quite a bit of interest in their assets. According to GM, hedge funds and private equity groups now control some 20 of its suppliers. Last year, a Japanese components maker controlled by the Ripplewood private equity fund snapped up Metaldyne, while financier Wilbur Ross bought Lear's European interiors business.

The prescription for survival for volume automakers is not to nurse their existing parts suppliers back to health, but to become designers and marketers of cars manufactured elsewhere, notably in China, India or in other parts of the world where production is currently cheap. They need to use their brands and dealer networks, not their rusty -- or even state-of-the-art -- production facilities. Otherwise, they will be beaten hands-down by the likes of SAIC, the top Chinese car maker, which has produced its own version of a Rover 75, called Roewe 750, and plans to launch 30 new models under this name.

Not surprisingly, the outsourcing process has been spearheaded by those companies that have been hurting most. GM and Ford have been announcing large increases in their parts outsourcing to China, to the tune of billions of dollars. However, just as in the automotive parts industry the infusion of money has prevented a badly needed consolidation, so among automakers the arrival of Cerberus -- to be followed no doubt by other bloated private equity funds -- is likely to slow outsourcing and consolidation.

The result will be continued dogged competition in the auto industry, thinning profit margins and ups and downs for most volume car makers -- and some luxury ones as well. But when push comes to shove, and some venerable national automaker, be it Nissan, Fiat, Peugeot-Citroen or Chrysler, looks like it is failing, the government is likely to step in and bail out both the company in question and the investors who put their money into them.

---

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007

Reprints Discuss this story
This is where the comments go.