Leading Auto Analyst Predicts Political Intervention for U.S. Auto Industry

Courtesy Murphie Barrett Public Affairs Coordinator, AIADA

Washington DC February 27, 2006; Many unanswered questions and broad predictions surround the domestic auto manufacturers’ current business environment. AIADA’s February 15th Power Talk featuring John Casesa, former auto analyst for Merrill Lynch, provided dealer members with not only an in-depth, analytical account of the current happenings, but also shed some light on what the future may truly hold for the U.S. auto industry.

During his presentation “The Recapitalization of Detroit: A View of the Current Crisis,” Casesa broke down the grim situation into three interrelated concepts: the current operational landscape, “the war” brewing between the Detroit Big Three and the international linemakes, and outlined a potential outcome of “the crisis.”

The Landscape

Casesa began by outlining the U.S. auto industry’s business environment. In recent decades, consumer demand remained relatively stable while interest rates have sharply declined since 1980. In response, consumers didn’t save their money. They bought more cars. The amount financed jumped to about $26,000 and the average maturity of these loans is now 63 months.

After the catastrophic events of 9/11 consumer confidence dropped dramatically and has since only slightly rebounded. The auto industry lead by General Motors was able to take advantage of low interest rates and public liquidity at the time, but this served only to “mask the underlying profit weakness,” explained Casesa.

The “volatile inventory supply” combined with pressure on the pricing market from non-Big Three manufacturers has forced Detroit to cut prices in order to maintain their market share.

“Consumer Price Index for New Cars and Trucks collapsed in the late 1990s and got progressively worse until 2003. It only recovered in 2004 and 2005 because Detroit was forced to rein in production to cut its inventories,” said Casesa.

So what does all of this mean for profits? “The collapse in pricing and the pressure on retail car prices has caused a domino effect of lower profitability throughout the value chain.” As OEMs and suppliers experienced drops in their operating margins and returns on assets, dealers have also witnessed their pretax return on equity decline for the past three years.

And 2006 looks to be no different. “I think 2006’s return may be down a little bit again,” predicted Casesa.

“Detroit’s first reaction is to retreat,” noted Casesa. Casesa forecasts a relatively flat production capacity for the next five or six years, mostly because non-Big Three manufacturers’ new flexible low cost capacity is driving out the Big Three’s older inflexible high cost capacity in the Northeast.

He contends that GM and Ford’s recently announced restructuring plans are simply an effort to catch them up to what’s already been happening to their market share in the last few years.

“The oligopoly is gone,” Casesa said. “GM’s decline in market share from 42 percent in 1985 to 26 percent in 2005 no longer allows it to put up a price umbrella under which other corporations can establish their prices.”

As both domestic and international linemake manufacturers’ market shares begin to converge, Casesa predicts the situation will mirror that of the European new vehicle market – no OEM has more than a high teens percentage of the market.

The War

So what determines market share and competitive advantage? The product.

From 1987 to 2005, 35 new vehicles have been introduced per year on average. Over the next few years, Casesa asserts that this number will rise because U.S. automakers have not yet decided to cut brands’ models and the market is being flooded by new models as Asian automakers expand their product line.

The immense acceleration in product cycles – the average showroom age of vehicles is approaching 2.5 years – has been very beneficial to consumers and has been a big factor in keeping demand stable.

From 1995 to 2005, GM has replaced 14 percent of its volume per year, its average showroom age was 0.8 older than the industry average and it lost 5.8 percent of its market share. By contrast, the Japanese replaced 20 percent of their volume per year, their average showroom age was 1.5 years lower than the industry average, and they have gained 7.2 percent of the market.

International manufacturers also have the ability to spend more of their resources on research and development thereby allowing the virtuous cycle of market share gain to continue.

Bottom line according to Casesa: “The more product you replace the higher your market share. The less product you replace you’re more likely to lose some of your share.”

The Crisis

In 2005, the Big Three lost 3.7 cents per every dollar of auto sales. “These companies are bleeding a tremendous amount of money in a stable environment,” said Casesa.

Drawing upon parallels of the U.S. steel industry and the U.S. airlines, Casesa predicts that the situation in Detroit will get worse before it gets better and expects the following to happen in the short-term:

* New deal or serious confrontation with UAW by September 2007 * Increased demand risk given the incentive pull-ahead, higher energy prices, and higher interest rates * Accelerated supply base consolidation as more weak companies fail * Further shift in dealer capitol away from GM and Ford * Radical downsizing of GM and Ford

Casesa asserts that restructuring is inevitable and that the Big Three have two options: incremental or radical restructuring.

He describes the incremental approach as delaying in addressing the root issues until there is no other choice, whereas the radical approach dictates that the Big Three address the critical issues including management, corporate structure, brands, and labor before their balance sheets implode.

The route taken by the Big Three will likely depend on key players decisions. “Players such as the UAW, Jerry York (the investor representing Kirk Kerkorian on GM’s Board of Directors), Steve Miller of Delphi, and those running the corporations are the ones most likely to catalyze action,” said Casesa.

Casesa believes that some form of "political intervention" is "very likely" given the domino effect that exists among the OEMs, suppliers, and dealers.

“The nightmare scenario is if one of these companies were to seek bankruptcy protection the others would have to do it too to get the equivalent deal and remain competitive – that would have a terrible domino effect.”

The Future

According to Casesa, there will be a better demand and supply balance as OEMs reduce their number of brands and have more money to spend on research and development resulting in more focused, desirable product portfolios.

There will be fewer, stronger suppliers with balance sheets that enable them to invest in technological development and drive a lot of innovation within the industry. Finally, there will be consolidated, more profitable and consumer-friendly dealers as consolidation occurs at the OEM level.

The audio recording of the John Casesa Power Talk will be available on AIADA’s website shortly.