Changing Course: The Chrysler Deal, Rising Gas Prices and Other Car TalkPublished: May 30, 2007 in Knowledge@Wharton
Earlier this month, Cerberus Capital Management bought 80.1% of Chrysler Group from German auto maker Daimler-Chrysler, effectively ending a nine-year marriage between the two that never quite worked out. The expectations created by this acquisition are huge, and revolve in part around Cerberus's ability to make a deal with the United Auto Workers union that would include restructuring billions of dollars of retirement and health-care benefits -- a burden that both Ford and GM -- but not Toyota -- also carry. We asked Wharton management professor John Paul MacDuffie, co-director of the International Motor Vehicle Program, to give his views about Chrysler, Cerberus, high gas prices and other auto-related issues.
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Knowledge@Wharton: Now that the dust has settled, what do you make of the Chrysler deal - is it good news, bad news, and for whom?
MacDuffie: I think that it's a fascinating moment in the history of the auto industry and I suppose in the history of private equity as well. This is certainly the first time that something as big and complicated and iconic as one of America's classic car companies has been purchased by a private equity firm. There are a number of different ways it could go and I'm watching it very closely.
We're used to private equity firms by now, at least stereotypically moving very quickly to just strip out all kinds of costs, maybe break things up and sell off assets in order to get a fast return and perhaps re-sell the firm. I think that that's not going to be such a viable option for Cerberus. But that may be the way that they are going to approach it. Private equity of course is supposed to have the advantage of taking management out of the spotlight of quarterly profits, industry analysts and prying shareholder eyes - and that hypothetically gives them a chance to take slower, more patient routes to turning a company around.
I would hope -- and I have some optimism -- that some of the Cerberus team will have some creativity and imagination about how they approach the Chrysler situation at this point and time.
Knowledge@Wharton: How soon do you think Cerberus can turn Chrysler around, if they can at all?
MacDuffie: One of the big sources of cost in this industry is supplied parts. One notion would be that Cerberus would try to find all sorts of cost savings in that area. But frankly, all of the big auto companies have been for years stripping costs out of the supply chain. The presence of competitors in places like China has certainly helped with that. I question how many easy-to-get cost savings there are in those kinds of traditional places.
There's also an argument that the problems of Chrysler and also GM and Ford are less on the cost side than on the revenue side. They haven't been so successful in recent years at attracting customers to their new products. So what does it take for Cerberus to generate new products out of Chrysler that will get people excited, while of course managing the cost side very carefully? As you mentioned in your intro, there are a lot of eyes on the UAW contract and all of the costs involved with that. I'm not one who holds the view that that's been the main thing saddling the Big 3. But it's an undeniable cost for them, and GM and Ford have both already negotiated very sizable reductions in their health care obligations to the UAW. DaimlerChrysler was not successful in reaching a similar deal with the UAW. At the time, the UAW saw DaimlerChrysler as financially the strongest of the three. That has clearly changed.
But I imagine in all of the run-up to the sale of Chrysler, there's been a lot of thinking going on within Chrysler management, within the UAW leadership and of course within the new buyers at Cerberus, about how to tackle this in the upcoming negotiations. Many people are intrigued by something that has happened recently at Goodyear. At Goodyear, the United Rubber Workers which are now part of the United Steel Workers and the company negotiated a deal where they set up a new health-care fund that is managed by the Union.
All of the health care liabilities of the Goodyear workers are transferred to that new fund. So, the company no longer carries the health-care liabilities. People are wondering if this could be a kind of creative option to the Chrysler-UAW negotiations this summer.... It would be a new approach. Cerberus might be in a good position to kind of break the mold and go in that direction.
Knowledge@Wharton: Picking up on what you said a few moments ago, a columnist in the New York Times this week suggested that in fact the problem isn't the UAW; that wages and the health and retirement benefits make up only about a tenth of the cost of an average car. He suggested that the problem is that auto companies stopped making cars that Americans wanted to buy and drive. Is this a simplification or do you think he has a point?
MacDuffie: Well, of course it's a simplification, but it's an appealing message in a number of ways. I think that it's easy to blame the labor cost legacy for problems that have been growing for the U.S. companies for many years. The real question about the health care and pension legacy costs is that $1,500 to $2,000 per vehicle. If you imagine that this money could be invested in putting more into the vehicle -- better technology, better interior materials, a little more work on some of the styling -- it might make the difference in attractive vehicles.
I also think a piece of what we've seen was the result of strategic choices by the U.S. companies in the 1990s to get away from the car business, in a sense, and move into the truck and SUV business. It was a protected part of the market, where there wasn't much foreign competition and these were hugely profitable vehicles. And, as we know, the industry had a really good run with those vehicles and nobody was complaining about them not building vehicles that consumers wanted. The sales seemed to demonstrate that they were anticipating those needs very well.
But, I think that it became a kind of addiction that was hard to break free of and so these companies missed some really important new design trends. The rise of car-based SUVs, of SUVs built on car platforms -- the Japanese companies had a 4 to 5 year head start on the U.S. companies in really getting viable products into the market place. That's been the largest growing segment in the entire vehicle market.
And then of course there is the bread and butter passenger sedan, which continued to be some of the largest selling vehicle segments. The Big 3 kind of turned away from that segment for years. It's hard to step right back and compete against the [Toyota] Camry and the [Honda] Accord and the [Nissan] Altima and some of these very strong core products -- now the Hyundai Sonata -- and right away start gaining market share against those tough competitors, when you've turned your back on that segment. These design things are not things that you turnaround overnight.
Knowledge@Wharton: How likely is it that Chrysler would declare bankruptcy?
MacDuffie: Well, I don't know enough about the inside of the financial situation. Everybody seems to think that Cerberus has gotten a very good deal, when they look at the purchase price that Daimler-Benz paid for Chrysler in 1997-98 of $36 billion and then they look at the price that Cerberus paid which was more around $6-7 billion. Of course, it's more complicated than that and that was for only 80% of the equity. I'm guessing that Cerberus would not have wanted to make a deal like this just to then try to use the bankruptcy route as a way to, for example, dramatically reduce labor costs or break labor contracts.
There's been enough of that going on in the auto industry, particularly among suppliers, for it not to be a crazy, out-of-the-question idea. But, I think that in my view and I think that many share this view, to take a major auto manufacturer into bankruptcy potentially has very different consequences than taking a supplier into bankruptcy.
All of the uncertainty that is raised about the future of that manufacturer, all of their products that are out there needing to be serviced, all of the people who have staked their business on the continuation of that company -- it's very risky if you take yourself out of the game for the period of going through a bankruptcy procedure. A lot of people may just decide to stop supporting your entire after-market products as well as, not to mention your products going forward. So, a clean start for a major auto manufacturer after bankruptcy is I think less viable than even for an airline. And, as we have seen that's been very common in the airline industry.
Knowledge@Wharton: How long do you think that Chrysler's current management can stay in power, given that Cerberus itself has a number of former auto executives that they could put in at a moment's notice, as head of Chrysler?
MacDuffie: I think it is a sign of perhaps the strength of the Cerberus offer that they went into it with eyes open knowing about auto companies, because of the very senior people that they've attracted to these automotive acquisitions. David Thursfield from Ford was head of manufacturing there and Ford of Europe for many years. And [Wolfgang] Bernhard of course worked at DaimlerChrysler for a number of years before he was forced out and then he worked at Volkswagen.
So these are people with a lot of knowledge and a lot of credibility. Everything that I have read suggests that they don't actually want to step into active management at all. And I don't think that Cerberus would push them in there unless they felt that something was going wrong. So, I think a lot will depend on how the Chrysler management teams feels... that they can buy into what Cerberus wants to do and that they're getting supported by Cerberus.
Certainly the CEO, Tom LaSorda, looks to be the kind of person with a lot of the right ideas, a lot of the right skills and a lot of the right credibility. You may have heard that he has an interesting family history which includes union leadership. And so he seems to be one of the right people to work closely with the union through this period. I don't expect a big turnover in Chrysler management, but I did see an announcement yesterday of some senior Chrysler person who is leaving. So, we may see some of what we saw after Daimler-Benz bought Chrysler, which is a bunch of people deciding that they are not sure that they want to stay on after the new regime.
Knowledge@Wharton: High gasoline prices have been the subject of almost daily media reports. Are they high enough to make people cut back on their driving and who is to blame -- who is making money off of this?
MacDuffie: Complicated question. You know I think that we're all kind of speculating when we imagine tipping points in gas prices that suddenly cause behavior change. People used to say "$3 was it" - because $3 was something that hadn't been touched in years and years. We're starting to sit above $3 for a more extended period of time. We've had the previous flirtation with prices this high.
I think that people adjust and acclimate to these things in all sorts of ways. They get used to things that used to outrage them and they also start to change their behavior. And they change things in small ways -- fewer trips or different decisions about maybe how far to drive on a holiday. Eventually they make different buying decisions about vehicles.
I know that sales of Hybrids are exploding; [Toyota] Prius I think particularly and some of the other and newer Hybrids, and there are more hybrid models that are being offered all of the time. Small car sales of course are way up and truck and SUV sales are down. Eventually I think that we can anticipate that this situation of high gas prices helps encourage more innovation by the manufacturers to move more quickly to fuel efficient vehicles. Again, you don't overnight get a supply of vehicles that is going to change people's expenditures week by week on gasoline.
The other question is whether there ends up being any political consequences of how consumers feel about these things. I don't really see at the moment anything that adds up to a political action to try to do something about gas prices. The oil companies are always very careful at times like this. They know that they are making a lot of money and they know that people are often suspicious and angry at them.
I suspect that one of the things that will start to be part of the consumer perception of oil companies is how much they seem to be doing to help support the development of alternatives to petroleum based products. I think that there probably will be some that will be more progressive in that area. And I think that over time that will have some consequences in how the public views them.
Knowledge@Wharton: But what is the incentive for them to be that progressive? I mean they would certainly be hurting their own profits if they came up with alternative sources that don't involve their products.
MacDuffie: Yes, I agree. I think that probably the incentive is a long-term one and it's one of wanting to be in the game of other energy sources rather than just trying to protect the shrinking base of the old energy sources. Obviously, there is a lot of political steam mounting around things like ethanol, which not only is attracting a ton of investment money but is getting subsidies from the government and the like. They could choose to simply fight a rear-guard action of trying to defend things that subsidize them or help them and resist the others. Or, they could try to find ways to be part of developing the new sources.
You know, I'm just a believer that we're going to need a wide range of new fuel sources and new technologies in order to make any progress with some of these challenges with greenhouse gases and environmental consequences. And, that's going to mean a lot of room for innovation and experimentation. I don't see any one solution or any one winner - certainly not in the technological sense, but I don't think even in a political or a regulatory sense.
Knowledge@Wharton: I've heard a report on the news that professed to scientifically have discovered the exact price of gas that would be the tipping point for people. They came up with a figure and I think it was $4.23 a gallon. Do you have a tipping point or do you think there is a specific point when you think people are really just going to change their habits dramatically -- not just incrementally or now and then?
MacDuffie: This must have been a U.S. focused study because of course gasoline is already much more expensive than that in most parts of the world.
Knowledge@Wharton: Yes -- it was definitely U.S.-based.
MacDuffie: I think that looking at parts of the world where gas is very expensive, it's not that people don't drive. They tend to buy smaller, more fuel efficient vehicles and often that fits other aspects of where people live in terms of residential housing density and parking availability and the like. I think maybe to me the more interesting question is when people begin to have a personal role in either contributing to the problem or to the solution.
I think that there can be a first response which is, "I have my life the way I want it and my cost of living is going up because of these gas prices and that's outrageous." And to get to the next stage which is, "Well, things about my life may need to be reconsidered in light of the way the world is changing." That could cause people to make dramatic changes in their driving behavior.
It could take them [rethink] how far away they live from where they work and so how long their commute is. It could filter into different people's consciousness in different ways. I think the problem with the tipping point notion is that it imagines that the price of gas instantly triggers reduction in the use of gas as the kind of direct link. I think it will be a little bit more diffused -- but I think it will happen.