Monday, March 10, 2008

Will GM Or Ford Survive The Current Economic Crisis?

With the price of gasoline in the U.S. continuing to go up while consumer spending is going down, there are concerns about the continued viability of the U.S. auto manufactures to survive this economic crisis. Certainly, the U.S. auto makers faced and survived previous economic challenges – such as the 1973-74 gas shortage[i], 1979 gas shortage[ii], 1980’s Japanese car invasion, 1998 workers strike, 1990-91 recession, and the 1990’s Korean car invasion, to name a few – however, the challenges facing the U.S. automakers this time appears to be more difficult than in the past.

What Is Different This Time?

In a word: PROFIT

GM and Ford had been profitable year after year up until 2000. According to Institute for Foreign Economics, the combined annual profit of the three major U.S. automakers, including Chrysler, was $13 billion a year from 1993 to 2000[iii].

Since 2001, which was the turning point for GM and Ford, they have been losing market shares to foreign makers, especially the Japanese, who enjoyed the foreign exchange advantage as their currency went from 116 yen to a dollar in January 2001 to 135 yen to a dollar at the end of 2001. In fact, Morgan Stanley estimated that Toyota earned $125 per vehicle for every one yen drop versus the dollar[iv]. In addition to lower prices, Japanese automakers were producing better built cars with better ergonomics.

Now, after years of trying to compete with foreign automakers on price, incentives, and low financing rates, GM and Ford are in a catch-up mode, particularly with the very items that lost them the market share in the first place: building ergonomically designed, high-quality cars at an attractive price.

According to GM’s website, their FY 2007 financial results were bleak:

“General Motors Corp. (NYSE: GM) today announced a 2007 calendar-year adjusted net loss, excluding special items, of $23 million, or $.04 per diluted share. This compares to adjusted net income of $2.2 billion, or $3.84 per diluted share in 2006, as significantly improved automotive performance was offset by large losses at GMAC. Including special items, the company reported a loss of $38.7 billion, or $68.45 per diluted share, compared to a reported loss of $2 billion, or $3.50 per diluted share in 2006. The loss is almost entirely attributable to the non-cash $38.3 billion special charge in the third quarter related to the valuation allowance against deferred tax assets.”

In their Future Outlook, GM states, quite optimistically:

“Operating cash flow is expected to be relatively flat in 2008 versus 2007, despite planned increases in capital spending to about $8 billion, up from $7.5 billion in 2007. GM remains confident in the 2010-2011 opportunities to further improve earnings and cash flow.”

So, GM is forecasting no improvement in earnings until 2010.

How about Ford? Well, they also sounded optimistic about their 2007 financial results:

“Full-year net loss of $2.7 billion, an improvement of $9.9 billion from 2006. Fourth-quarter net loss of $2.8 billion, an improvement of more than $2.8 billion from 2006.

For the full year, Ford's worldwide Automotive sector reported a pre-tax loss of $1.1 billion, compared with a pre-tax loss of $5.1 billion a year ago. The improvements primarily reflected higher net pricing, lower costs, and favorable mix, partially offset by unfavorable changes in currency exchange rates, and higher net interest expense.”

As for their future projection, they were not as adventurous as GM, as Ford only talked about 2008. Even then, the outlook is not rosy:

“Although our Automotive operations are improving on a year-over-year basis, the U.S. economy is slowing and the outlook for the auto industry remains challenging," said Ford President and CEO Alan Mulally.

Risks GM And Ford Must Overcome To Survive

GM and Ford - Risk of irrelevancy: As Japanese and European cars continue to dominate JD Powers Quality survey, year after year, GM and Ford will become more irrelevant, especially to the younger generation of car buyers. Toyota has already been working to attract the younger generation through their Scion specialty brand, which does not even advertise on Toyota’s own website. While Ford and GM, with their recent revival of the muscle cars, may get a little boost from the nostalgia crowd of baby boomers, they have not made any serious traction with the younger buyers, who are opting for Japanese cars.

This issue was clearly noted by a February 2006 study Vehicle Choice Behavior and the Declining Market Share of U.S. Automakers[v] by Kenneth E. Train and Clifford Winston. This study concluded that the way forward for GM and Ford is to offer what a good quality mid-size car that is generally pleasing to the public, reliable, and priced to compete [bold and italic added for emphasis]:

We find that the U.S. industry’s loss in share during the past decade can be explained almost entirely by relative changes in the most basic attributes of new vehicles, namely price, size, power, operating cost, transmission type, reliability, and body type. The result is surprising in its simplicity, implying that it is not necessary to resort to the plethora of explanations just described. Arguments based on subtle attributes such as the design of interior features, unobserved responses by consumers to vehicle offerings, or even measurable attributes beyond those listed above do not play a measurable role in the industry’s competitive problems. Similarly, changes in loyalty patterns, whether an automaker’s product line is broad or narrow or includes a hot car, and changes in dealership networks do not contribute much to the industry’s decline. Our finding suggests that U.S. automobile executives should focus more attention on understanding why their companies seem unable to improve the basic attributes of their vehicles as rapidly as their foreign competitors are able to improve their vehicles’ basic attributes, and try to remedy the situation.

GM - Risk of Current Labor Unrest Continuing Much Longer: GM is again being adversely affected by another labor strike, this time with the American Axle and Manufacturing Holdings Inc., a major parts supplier. Given the current oversupply of unsold inventory, the strike will have a muted effect on car sales, if it is a short one. However, given the width of the gap in hourly pay, this may last awhile, eventually hurting GM in the revenue numbers. According to a MarketWatch report:

“Talks resumed Thursday for the first time since the strike began. The talks focus on issues such as American Axle's aim to pare its total labor cost, which includes benefits, to $27 an hour from where it stands now at $73 an hour.”

GM - Risk of Funding Retiree Benefits: According to GM’s website, the funding shortfall of “approximately $4 billion will be funded with a short term note maturing January 2010 with interest at 9 percent.” According to CNN Money, there is an additional $33 billion to $36.5 billion that GM would have to put into the healthcare trust. However, GM’s 2007 financial statement notes that the funding of this will be through a series of derivatives to effectively reduce the $40 per share convertible note to $36 per share, if it works. Moreover, this structured finance would entitle GM to recover the additional economic value provided if the GM stock price appreciates to between $63.48 and $70.53 per share[vi]. This sounds like GM setting itself up for another fight with the Union on benefit shortfall come 2010.

Ford - Risk of Bankruptcy: In 2006 Ford underwent a major restructuring dubbed the “The Way Forward.” Through drastic cost cutting, plant closing, worker buy-outs, and sale of subsidiaries, Ford had projected to return to profitability by 2009. Ford effectively boxed itself into a corner by taking out $23 billion in financing by mortgaging its assets. While Ford had $34.7 billion in cash at the end of 2007, their projection of spending $6 billion on capital improvements in 2008 while expecting losses again on its automotive unit, Ford will be burning through their cash very quickly[vii]. With declining sales projected for 2008, the potential for Ford to enter bankruptcy will increase as 2008 progresses. This is clearly evidenced by Fitch’s February 2008 rating action, which rates Ford’s issuer default as 'B' with a negative rating outlook.

Given that the U.S. economy is in a recession and may be heading toward a depression, the likelihood of GM and Ford being able to return to profitability in 2008 is seriously questionable.

May your trading be profitable.

Ed Kim

DISCLOSURE: The author holds no positions in GM or F at this time
[iii] , page 140
[iv] , page 142

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