Glenn Mercer

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THE AUTOMOTIVE CRISIS: HOW WE GOT HERE, WHERE WE ARE HEADED,

AND WHAT WE CAN LEARN

(With some implications for Real Estate, Economic Development, and Business Generally)

September, 2009

Glenn Mercer

Some upfront housekeeping

Thanks are due to:

• My hosts, IAMC (especially Hazel Pankey) and session sponsors (Lubbock EDA and McCallumSweeney Consulting)

• IAMC members who provided input: Jeannette Goldsmith, David Hocker, Ron Kitchens, Jennifer Lantz, Doyle Shea, Bleecker Totten, James Winter.

• My sources, including CasesaShapiro, CSM, Key Bank, BEA, Ward’s Sean McAlinden, Dennis DesRosiers, R L Polk, Merrill Lynch, Comerica, etc. etc.

Caveats are:

• All errors and interpretations are my own• A North American (rather than global) focus• A discussion of the automotive crisis, not the broader recession

For questions, more information, data, etc.: gamercer2@gmail.com

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Contents

• How we got here: causes of the disastrous impact on the Detroit 3 of the volume collapse:

– The scale of the collapse– Detroit’s disproportionate suffering– Causes of the Detroit problem: short-, medium- and

long-term factors

• Where we are headed: an attempt at a forecast

• What we can learn: lessons from the fall

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The scale of the collapse: the industry drives off a cliff

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Detroit’s disproportionate suffering: the Big 3 hit hardest

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GM + Ford + Chrysler

Transplants and Imports

US Sales: Detroit share falls from 75% in 1985 to ~45% in 2009e

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Detroit’s disproportionate suffering: 2 out of 3 file bankruptcy

• General Motors, after its bankruptcy, is now owned by a consortium of the US and Canadian governments, the UAW, and former bondholders

– Congratulations! Everyone in this room owns about $150 of GM

• Chrysler, after its bankruptcy, is now owned by a consortium of the US and Canadian governments, the UAW, and Fiat

– Still burning cash, perhaps $500 mm per month?

• Ford avoided bankruptcy, but primarily by mortgaging itself in 2006

– Roughly $25 billion raised; even the Blue Oval symbol and trade names such as Mustang were pledged

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Putting the bankruptcies in perspective

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Source is Bankruptcydata.com; scale is billions of $ of pre-bankruptcy assets

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But shouldn’t we have seen this coming? In market share…

Source: Ward’s AutoInfobank

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

YTD 2009

GM Ford Chrysler Korean European Toyota Honda

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… and in profits?

Source: Moody’s, Company Reports; Casesa Shapiro Group estimates for 2007 Chrysler results and for 2008 Big Three results

12.8

%16

.0%

16.1

%15

.0%

15.4

%12

.7%

9.8%

12.5

%10

.5%

4.8%

10.2

%10

.8%

9.8%

4.0% 4.

7%9.

2%9.

3%8.

2%5.

2%-3

.4%

0.4%

2.6%

8.5% 9.

8%7.

5%4.

9%8.

6% 9.2%

7.9%

1.7%

-3.2

%1.

8%3.

9%9.

0%7.

6%6.

2% 6.9%

6.2% 7.

6%5.

6%0.

2%2.

9% 3.7% 4.2%

-0.8

%-2

.0% -1.1

%-7

.9%

-10%

-7%

-4%

-1%

2%

5%

8%

11%

14%

17%

20%1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Operating Margin

Detroit Three Operating Margin

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Causes of the decline and fall

• Short-term factors: debt, debt, and more debt

• Medium-term factor: drunk on trucks?

• Long-term factor: outmoded basic beliefs

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Short-term factor: debt. The case of General Motors

Business School 101: Companies facing cyclical markets should not carry a large burden of debt, in order to survive downturns.

GM’s debt exposure (year end 2007, prior to current crisis):

•Owed to banks: long-term bonds: $33 billion•Owed to workers: retiree health care: $47 billion•Owed to workers: pensions: $11 billion•Owed to suppliers: (negative) working capital: $34 billion•Owed to dealers: (US only) excess car inventory: $15 billion

… on revenue of some $180 billion

Source: company financial statements; all figures exclude financing captive (GMAC)

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Illustration of GM’s debt problem: Toyota comparison

Toyota (and Honda similarly) can turn to its business partners for funding to get through a downturn; GM drew down all its sources, and so had to turn to Washington for funds.

Debt exposure (year end 2007, prior to current crisis):

GM Toyota• Owed to banks: $33 $4• Owed to workers: RHC $47 $0• Owed to workers: pensions: $11 $6• Owed to suppliers: $34 $13• Owed to dealers: $15 $0

… on GM revenue of some $180 billion, Toyota some $250 billion… and GM equity of negative $35 billion, Toyota positive $115 billion

Source: company financial statements; all figures exclude financing captives; Toyota FY ending 3/2008

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Medium-term factor: the truck boom leads to a car bust.

Even as the American market collapsed, the Detroit 3 lost share within that market. How did this come about? This is a development that has gone on for years*.

Hypothesis as to the factors behind this weakening:

5. The truck boom (SUVs and pickups) earned the Detroit 3 vast profits…

7. … which they used to fund “adventures” rather than reinvest in the core business…

9. … leading to relatively neglected and uncompetitive car product lines, once the truck boom ended.

* “The Detroit 3 have lost market share in the USA-plus-Canada every year since 1993.” – Dennis DesRosiers

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The truck boom of 1990-2005

It is hard to overstate the shift to light trucks in the USA over the years (due to regulation, consumer preference, and marketing).

Source: Sean McAlinden from Ward’s data

Millions of units sold, US market

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The truck boom of 1990-2005

It is also hard to overstate the flood of profits that flowed from the American love affair with light trucks. See the example of Ford’s Michigan Truck factory:

“… [ in 1998 ] the Michigan Truck Plant had become the single most profitable factory in any industry anywhere in the world. It was cranking out 1,040 full-size sport utilities every workday. The factory’s annual production was worth almost $11 billion – greater than the global sales for Fortune 500 companies like CBS, Texas Instruments, Honeywell, and Nike… The factory’s profits from those sales were even more spectacular: about $3.7 billion in pretax profits… while Ford had 53 assembly plants worldwide, the Michigan Truck Plant accounted for a third of the company’s entire profits. There were fewer than 100 companies in the world that earned more than this single factory did in 1998…”

Source: Keith Bradsher, High and Mighty

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The truck boom of 1990-2005 PERSONAL OPINIONS

With profitability assured by the cash flow from trucks, Detroit’s Big Three spent much of the 1990s engaged in all sorts of adventures… not necessarily related to the core business of making cars.

• Ford bought Aston Martin, Jaguar, Land Rover, Volvo, and Hertz, embarked on a series of “downstream” business extensions (e.g. purchasing car maintenance companies, collision repair shops, and salvage yards), spun off Visteon… and then unwound all these

• GM started and then stopped EV-1, diverted large sums into fuel cell research, spun off Delphi, sold Hughes Aerospace, aggressively expanded GMAC into home mortgages, bought Daewoo Motors*, got into a deal with Fiat and then back out, starved most of its alliances (Suzuki, Isuzu, Saab)… all for nought

• Chrysler of course “cashed out” (to the great benefit of its shareholders: the $36 billion paid would today buy Ford plus GM plus Daimler itself, with about $6 billion left over) by selling itself to an unsuspecting Daimler

* A move that is considered very sound by many observers.

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The truck hangover: uncompetitive cars

Partly as a result of the truck boom, Detroit allowed its vehicle platforms to age relative to the competition, which as a result gained share.

Age distribution of NA product platforms 1996-2008

Green = 0-2 years old; yellow = 3-4; red = 5-8 years; black = 9 or more years

Source : Dennis DesRosiers

Glenn Mercer

Context: Critics of the Detroit automakers recite a long litany of explanations for apparently foolish actions: stupidity, evil intent, disregard for the environment, arrogance, refusal to learn, inward focus, etc. I find these assertions unsatisfactory, preferring instead to identify the incentives that can explain seemingly suboptimal behavior.

Thesis: The Detroit automakers suffer from adherence to two core beliefs (one related to demand and one to supply) that drive a wide range of behaviors. The reason they cling to these core beliefs is that they held true for many years, and as large firms can be slow to revise views, they have only recently realized these two have become obsolete.

Prediction: As Detroit goes through its restructuring, obsolete views such as these will be swept from the system, allowing a more successful mindset to emerge… assuming the companies survive the crisis.

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Long-term factor: outdated beliefs

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The demand-side core belief: Form trumps function.

• Definition: cars = self-expression, status symbol, “my face to the world”• Strategy: slow upgrades of functionality, more rapid shifts in appearance• Successful when: cars are novel, one car per household, few other

status symbols, car quality low, ability to differentiate high• Genesis of belief: the oligopolistic 1950s and 1960s, when an otherwise

unchanged model could soar in sales with a styling change• Exemplar: 1965 MY Ford Mustang: an otherwise-unchanged rebodied

Falcon that sold 1 million units in 18 months (Ford expected 150,000)

This belief no longer holds:• Cars are now seen by many Americans as appliances• In the USA there are now ~2.5 vehicles/household• Families now display status also via phones, iPods, vacations, kitchens…• Car quality is high enough to no longer drive rapid purchase cycles• Styling’s ability to differentiate lower (due to regulation, aerodynamics)

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Long-term behavioral factors: Core Beliefs

Impact:

3.Policy of upgrading vehicle functionality slowly, opting instead for sheet metal and model name changes (Ford midsize sedan names since 1980: 500, Fusion, Granada, Taurus, Taurus again; Toyota: Camry)4.Strategy of betting on “flashy” individual new model launches, which have short half-lives (e.g. Chrysler 300, Pontiac Fiero) rather on steady updating of entire lines (e.g. BMW 3 5 7)

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Styling as a differentiator: reduced impact?

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The supply-side core belief: Scale trumps efficiency.

• Definition: economies of scale are the key to profitability• Strategy: pursue capacity via organic growth or acquisition; and for any

given capacity, always produce the incremental unit• Successful when: fixed costs of product development and manufacturing are

very high, market is in a growth phase, price discrimination is easy• Genesis of belief: from the Model T onward into the 1980s: production

typified by inflexible large transfer lines, product development manual and complex, market steadily growing, external styling and branding conceal identical mechanicals under varying model names

• Exemplar: 1965 GM B body sells 1.7 mm units in one year, under names LeSabre, Bel Air, Biscayne, Impala, Caprice, 88, Bonneville, and Catalina

This belief no longer holds:• TPS recasts the value equation to waste minimization and flexibility, from

scale maximization; CNC machines, CAx tools, etc. aid the switch• Developed markets mature, reducing capacity to absorb excess units• New competitors and smarter consumers break the pricing paradigm

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Long-term behavioral factors: Core Beliefs

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The ill effects of the belief in “scale economies above all else” are several:

• A focus on maximizing production leads to a belief that all units are equal, from a Maybach to a Mercury to a Mazda, regardless of varying margins, leading management to slight profits in favor of unit market share (thus the smallest OEM sampled has the best returns to shareholders)

• When the goal is maximizing output, any costs of complexity are ignored: “incrementalism is free.” Thus GM sells fewer cars than Toyota, but stocks roughly three times as many part numbers, at great cost.

• In pursuit of more volume, OEMs push into developing markets, despite low per-car profits: thus forecasts show that by 2015 most of global unit growth will be in emerging markets; but the developed world will likely still control some 75% of global revenues -- the same as today

• With a focus on units moved rather than on profits made, management can lose sight of the fundamentals, leading to “strategy by slogan” (e.g. “first mover advantage”); evaluation of winners and losers by unit share, not by bottom line results; and the cult of the “visionary” CEO.

• And finally, pursuit of scale at all costs leads to M&A activity in order to grow, despite the poor track record of OEM mergers.

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Impact of the belief in scale

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The Poor Track Record of Western OEM Mergers (partial list)

GM-Saab bankruptGM-Suzuki exitGM-Fuji exitGM-AmGen/Hummer exitingFord-Jaguar exitFord-Land Rover exitFord-Aston Martin exitFord-Volvo exitingFord-Mazda success1

Chrysler-Simca exitChrysler-AMC successFiat-Lancia failureFiat-Alfa Romeo failureVW-Skoda success2

VW-Audi success3

VW-SEAT failureBMW-Rover exitRenault-AMC exitRenault-Nissan success4

Renault-Dacia successDaimler-Chrysler etc exitPSA-Simca etc failurePeugeot-Citroen success?

1: only after many years2: but Skoda was rebuilt from scratch3: Piëch has suggested this is not so4: an alliance, not a merger

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NB: “Success” and “failure” assigned according to whether the merger achieved stated goals of the acquirerNB: I leave it to my audience to evaluate the Japanese M&A track record, e.g. Toyota/Daihatsu

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Contents

• How we got here: causes of the disastrous impact on the Detroit 3 of the volume collapse:

– The scale of the collapse– Detroit’s disproportionate suffering– Causes of the Detroit problem: short-, medium- and

long-term factors

• Where we are headed: an attempt at a forecast

• What we can learn: lessons from the fall

Glenn Mercer

One qualified forecast for total NA sales (CSM)

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CSM projects a slow but steady recovery to historic levels… I agree

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To assert “no recovery” implies belief in trend reversal (1)

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SCRAPPAGE: At present new sales are running below annual scrappage for the first timesince World War II

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Trend reversal? (2)

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VMT: Do we think that the current dip in vehicle miles traveled is an inflection point?

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Trend reversal? (3)

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OWNERSHIP: What might happen to end the growth in cars per household?

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Trend reversal? (4)

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AFFORDABILITY: With any reasonable elasticity of demand assumed, sales seem likely to rise

Most affordable score since the index was first computed

in 1979!

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What about the outlook for individual OEMs? (1)

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All else being equal, nothing tracks/forecasts OEM market share as well as averageage of an OEM’s model lineup.

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What about the outlook for individual OEMs? (2)

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If this relationship holds, Detroit’s market share should continue to slip, all elsebeing equal (dealer counts, government aid, styling changes, powertrains…)

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Results by OEM, for 2013

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Brand Current share %

Expected change

Resultant 2013 share %

Comments

GM 20 -5 15 Organic and M&A

Ford 16 +3 19 Newest line

Chrysler 10 -6 4 Viable? Fiat role?

USA 3 46 -8 38 Tied with J3

Toyota 16 +1 17 Slowing

Honda 11 +3 14 Efficient engines

Nissan 7 +1 8 Slowing

Japan 3 34 +5 39 Tied with USA 3

Hyundai/Kia 7 +3 10 Economical

Europeans 7 0 7 VW BMW, MB ↑ ↓

Other 6 0 6 Mostly Japanese

Total 100 0 100

Forecast summary:

3.Demand does return to “normal,” though it will take time4.We will move from a Big 3 to a Big 6 (“Europeanization”): more balance, more market share to/fro versus steady trends5.Finally, a focus on profits rather than on volumes6.Hopefully, much clearer brand propositions (pull vs. push)7.As for Detroit, one view is that GM is okay unless it backslides; Ford is likely to gain thanks to product offensive (kudos to Mazda?); Chrysler’s fate hangs on Fiat et al.

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Contents

• How we got here: causes of the disastrous impact on the Detroit 3 of the volume collapse:

– The scale of the collapse– Detroit’s disproportionate suffering– Causes of the Detroit problem: short-, medium- and

long-term factors

• Where we are headed: an attempt at a forecast

• What we can learn: lessons from the fall

Glenn Mercer

Lessons from the fall: general business insights

• How we got here: eerily similar to the housing and financial crisis

• Lessons from all this might include:– Watch your debt load and “stress test” it for extreme scenarios!– Do not be distracted by the latest big trend (trends end)!– Challenge beliefs that “everyone knows” are true: they may not be!

• Looking ahead: all cycles look like inflection points when you’re in the trough…

• Additionally: economic uncertainty might make all real estate transactions more complex (e.g. should “government takeover” now be an explicit contractual clause instead of just force majeure?)

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Industry Short Medium Long

Auto Excess debt Truck boom Form trumps function; scale wins

Housing Excess debt Long GDP b. House prices can only go up

Finance Excess debt Derivative b. Markets are not correlated

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Lessons from the fall: real estate commentary

• Repurposing closed auto plants has been and will be very difficult:– There are success stories:

• GM Linden (NJ) becomes Legacy Square retail (Lowe’s , Super Wal-Mart)• GM Oklahoma City becomes Tinker AFB maintenance and repair facility• Guide plant (ex-GM/Delphi) (LA) to become V-Vehicle H/EV plant?• GM stamping plant (MI) transformed into Midlink Business Park

– But these may be few and far between:• GM and Chrysler alone to close 25 mm ft2 in Michigan; Ford on a similar path• Facilities closed in the bankruptcy may escape environmental cleanup liability,

making these plants hard for communities to deal with even at a zero price• Greentech initiatives (e.g. Michigan’s $700 mm in credits for battery manufacture,

Great Lakes Wind Network) are still nascent and relatively small

• New entrants (China, Asia, startups) may offer some new opportunities• There are opportunities in dealing with ~3,000 shuttered dealerships• The industry’s center of balance will continue to shift southward• Has the “Southern model” of incentives been vindicated? (simplistically:

Northern pattern is 85% tax abatements, 15% infrastructure; South is 40% tax, 45% infrastructure, 15% training, etc.)

• The local industrial base can never be too diversified

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The Southern Shift:

3.In 1979 South (AL GA KY NC SC TN) had 7.5% of USA automotive employment; in 2004 15%4.In 1979 South had 5 assembly plants; in 2008 135.Of all new parts plants opened between 1980 and 2006, 67% were in the South6.With Detroit 3 closures continuing, shift will accelerate

Source: Thomas Klier, Chicago Federal Reserve

Glenn Mercer

Final slide

Please contact me for more data, backup material for slides, additional questions, etc: gamercer2@gmail.com

Thank you!

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