On the Skids: Are U.S. Automakers Running Out of Time -- and Options?Published: October 29, 2008 in Knowledge@Wharton
The Big Three U.S. automakers can't seem to catch a break. Demand for their profitable and gas-gulping SUVs evaporated as oil prices surged to record highs through the spring and summer. Now, the global financial crisis is keeping consumers away from showrooms and limiting automakers' access to the credit that helps sustain them. GM and Chrysler, currently in merger talks, are reported to be running out of cash and are in line for early access to a $25 billion low-interest government loan fund intended to help American car companies meet new fuel-efficiency standards. Kirk Kerkorian, meanwhile, is selling his $1 billion stake in Ford. To be sure, the financial crisis is hurting car companies worldwide. Toyota says its sales will fall 2% this year, while China's Chery and India's Tata will have to carry on even though their emerging economies are no longer growing at double-digit rates. But the U.S. Big Three have suffered the most, with sales down by as much as 25% this year. Wharton management professors John Paul MacDuffie and Larry Hrebiniak talked with Knowledge@Wharton about the industry's challenges.
Knowledge@Wharton: Thanks for joining us, professors. Let's start in the U.S. Why are the Big Three in such a jam?
MacDuffie: They've been hit by more or less the equivalent of a perfect storm, I think, between being still in the midst of a recovery plan, which has included things like reducing labor costs, reducing health care and pension costs, trying to shift their product line to more fuel-efficient vehicles -- and oil prices obviously hit them in the middle of that. And now the financial crisis, the credit crisis, is causing them to not be able to extend loans to car buyers. They're being hit on all fronts.
Hrebiniak: Looking back to historically, what John Paul said, of course, is true. I would just add that over the years, probably in the last decade or so, decade and a half, they made a lot of strategic mistakes. You know, basically, years ago, they had a very favorable industry structure. Industry forces were positive. They had power over suppliers. They had power over buyers. Buyers didn't know much about buying cars. They had size, they had market share. It was an oligopoly -- three firms. All of a sudden, the world changes. Competition comes in. The customer gets much more knowledgeable, because of the Internet. Suppliers become more powerful. The UAW had a history with GM of bad relationships. And that's not carrying over positively right now. And so when you put all of that in perspective, and given what John Paul also said -- that in fact, you can see some strategic errors, and just inability to manage their company well.
Knowledge@Wharton: Well, as we know, GM and Chrysler are talking about merging with each other. Does that make sense?
MacDuffie: It's hard to see much strategic rationale for it. Chrysler has access to some cash, which GM could very much use. There's also talk about Cerberus, which owns Chrysler, being able to turn over its ownership stake in the GMAC, the credit arm of GM, as part of that deal. Everything else which you usually hear when there's talk of merger and acquisition, which is scale economies and synergies and being able to eliminate redundant products and redundant dealers, et cetera -- to me, the administrative effort to do that effectively is going to so overwhelm these companies at this point that it would swamp any benefits I think they could get.
Knowledge@Wharton: And they've been talking about it for some time. So despite that logic, is it likely to turn out that we'll have a Big Two instead of a Big Three, and perhaps in the future, something even less than that?
Hrebiniak: I would say this is probably going to happen. I agree that basically strategically it doesn't make a lot of sense. Yet I look at the other options they have, and there aren't that many. If they do merge with Chrysler, they're going to need something like $10 billion of infused equity just to pull off the integration. Just to meld the two companies. Just to do a whole host of things. There's going be a bunch of lay-offs, and whatever. But I don't know what the options are. It's going to happen. I don't think it's a great move, but it is going to happen. I also think it's a signal. I think even though the government has come out and said they're thinking of helping them, I think they want to go through a kind of sequential process that says, "Look. We've tried to solve our problems. If we integrate two companies now, we're really showing we're trying our best. And if this doesn't work, we can't have so many people be negatively affected in the economy. So government, please step in and help us. And -- we've tried hard." And so I think that's part of it, too. But strategically, it -- you know, one company has eight or nine -- eight brands. The other has three. You put them together -- I mean, together we'll have 10,000 plants. That's 10 times more than Toyota. All of these things put together say there are a lot of problems.
Knowledge@Wharton: Now, that $10 billion they would need to pull that off -- there aren't a lot of lenders lining up to provide the cash. And so there has been talk, as you said, of going to the government for some help. Today the White House said that they would likely qualify for the help under the TARP program. So should the government step in? Should the government save GM?
MacDuffie: Well, it's going to be politically complicated. Although at the same time, there are probably more favorable political conditions for such an action now than the last time it was brought up, which was less than a year ago. I do think that bankruptcy is probably the last option that these companies will want to pursue. For a durable good like a vehicle, for a company to be in bankruptcy introduces so much uncertainty in anyone's purchase decision, even maintaining of used vehicles. It's not like an airline. We've seen airlines go into bankruptcy sometimes twice and come out, and still have customers. But I think the feeling is -- no one's really tested it -- that with a car company, it would be very different. So there are the options of big mergers. There are options of smaller things, which involve selling off chunks of assets. Ford may sell off its stake in Mazda. There's talk of whether GM should or could sell Hummer. But there are things less than the big mergers. And I think the government, which has already approved, I think, a $25 billion loan fund for supporting the Big Three in the conversion to new fuel-efficient technologies, is probably ready to do more. The question would be the conditions. I think Obama has already said that he favors another $25 billion right away, and more dedicated to saving jobs. So in a funny way, the conditions are more favorable. But perhaps, as Larry says, there'll be some sort of necessary steps of industry consolidation before that could happen.
Knowledge@Wharton: Well, certainly the development of those efficient cars is very important in their competition against overseas manufacturers. Is that going to be enough, that kind of government assistance through the incentives going to be enough to fund that, or do you think that it's going to take something more?
Hrebiniak: It's going to take something more. If we recall, GM had a very nice electric motorcar and they killed it because of the reliance on gas combustion. And they basically said, "No. We're not gonna do this." So now, of course, they're doing it, because others are forcing them to do it. Whether they can get up to speed and do it as quickly, and get up there with Toyota and Honda and so on, is yet another question. Should the government bail them out? I don't think the government probably feels they have much choice right now. Because they did all this work, all this help for the financial institutions. And the argument was the pervasiveness of the effects if we let them go under would be disastrous. Well, the same with General Motors. If you stop and think, with General Motors, Chrysler, and Ford -- the number of people they affect not only directly in terms of employees, but suppliers. People who work. Related industries. The multiplier effect of all the implications of not helping them is going to be huge. So I feel the government's going to reason, "We've started the process. We've helped someone else. We're going to have to continue." I think that's what will happen.
Knowledge@Wharton: Ford doesn't seem to be in quite so deep a hole. Why is that?
Hrebiniak: They got into a better cash position about a year or so ago. They have some better brands. They do have Volvo, they have Mazda. And they did have some resurgence about a year or so ago, after having some pretty down time. Now, they just moved faster than General Motors and Chrysler. The fact that General Motors first picked Ford to look at -- they knew what they were doing. They were saying, "If anyone could help us it would be Ford more than Chrysler," quite frankly. But Ford wasn't interested. Now, Ford's in a little bit more trouble, because even investors there are pulling out and selling off. And so they might not be in as good a shape as I thought they were just a few months ago. But with their fewer brands and -- again, with Mazda and Volvo, they could sell those off. They could keep them. I think they're in a little better shape. Again, GM has eight major brands. Hummer and the GMC trucks are doing nothing right now. And I don't think Ford's in that position.
Knowledge@Wharton: Well, just last year, Ford sold its Jaguar division to Tata Motors in India, which makes me wonder if Tata and China's auto makers were really counting in their fast-growing economies that they had over there. And of course, the financial crisis has put the brakes on that, too. What does this mean for them?
MacDuffie: Well, their progress is going to be a lot slower. I mean, let's face reality. That they had counted on double-digit growth. They had predicted that. Matter of fact, Tata was one of the companies mentioned to pick up some assets from General Motors, or even merge with them, or buy some of their assets. All of that, I think, is going to be put on the back burner. The slowdown in the worldwide ecstasy, the financial crises, is going to affect Asia, it's going to affect Europe, and it's going to affect us here. And I think that they're just going to have to bite the bullet. And hopefully things get better.
Hrebiniak: Yeah. The Chinese have shown some interest in buying into companies outside of China, and starting to get into those markets before they would be able to export from China directly. But I think that they're going to have to keep their focus on their domestic markets, which will be slowed down. Tata has some demonstrated capabilities of managing these sorts of high-end brands that they've purchased. But most of their emphasis is on the Nano, the product they've developed for their own domestic market. So I expect it to stay that way.
Knowledge@Wharton: Now, Toyota is reporting this year that they'll have their first decline in sales since 2001. So I guess this means nobody's immune?
MacDuffie: Absolutely nobody's immune. And certainly Toyota's decision to invest in the larger pick-ups and SUVs -- you know, they just redesigned the Tundra. They just launched a brand new plant in Texas to build it -- means they've been hit with the same kind of steep fall of that end of the market. But of course, that's not a big part of Toyota's product line-up. It's not the core of its strategy. Those are unique products to the US. In most of the globe, they really are leaders in fuel-efficient vehicles. You could perhaps argue that Honda has the best product portfolio for these kinds of conditions, because they've stayed with a smaller number of products, and almost all of them have some drive-train innovation, because that's really the core of Honda's strategy. So perhaps right now, they look in the best situation. But Toyota's cash-rich, and they're very flexible and adaptive. They've already announced that they're going to convert an SUV factory planned for Mississippi to build the Prius in the US, the first country outside of Japan where that will be built. So I expect that they'll do just fine.
Knowledge@Wharton: What kind of time frame do you think we're looking at for this rough patch for the auto industry? Will the auto industry emerge from the financial crisis kind of behind the curve, or ahead of the curve? And how long do you think that might be?
Hrebiniak: Well, I think, they're currently behind the curve pretty badly, when you look at worldwide sales comparing them to Toyota, Honda, and some of the others. I think there are two questions here. Number one, will they emerge? And number two, how will they emerge, and when? So it's like -- I think even if they do emerge, if they get through these financial crises that they're going through now, if there is some sort of merger acquisition activity-- you're not going to see magical results. They're going to be behind the curve, and they're going to have to fight very, very hard to fight the erosion in market share. Fight the increase in cost. Right now, General Motors is spending over $1 billion more per month than it's bringing in. And so even with a merger, an acquisition, or whatever we might call it, with Chrysler and the need for that extra $10 billion, I don't see things turning around very quickly. I see them really trying to save themselves. And to answer your question, they're going to be behind the curve for quite a long time, quite frankly.
Knowledge@Wharton: But you think they can avoid bankruptcy?
Hrebiniak: They said they were going to do it at all costs. They said there is no option. That could just be good talk. Quite frankly, I'm not sure they can avoid bankruptcy. But it sounds good. What they're trying to say to the financial markets, their potential investors, and whatever, is, "Please don't give up on us." That in fact, "We're not going to go bankrupt. We are gonna fight through this." But I think it's going to be tight. Very close.
Knowledge@Wharton: Professor MacDuffie, are they going to make it?
MacDuffie: Well, there really are two auto industries in the US by now. There are the U.S.-owned companies, the ones we've always thought of as the Big Three. But there's by now a very large number of not only factories, but dealerships of not just Japanese, but Korean and German. And the French may end up with some role here, too, by -- if they end up with some assets through their own negotiations with GM. So will there be a thriving US auto industry? It'll be affected by the overall economic conditions. You know, there was a prediction of 15 million vehicles per year as kind of expected in a moderate recession. GM was basing a lot of its estimates on 14 million. The prediction for '09 is 13 million. So that's a dramatic percentage reduction from what everyone was counting on. How quickly will that come back? How quickly will auto sales come back? That's the kind of purchase that people do postpone when times are tough. They can't postpone forever. They may shift toward used cars and the like. So how quickly sales come back is obviously a big thing that affects both the healthier and the less healthy part of the industry. Whether they go under -- I think there will be a lot that happens from the government, as well as from these companies, to prevent bankruptcy. And I'm still a little skeptical of the big mergers. But I think there'll be lots and lots of assets moving around here before we see the final outcome.
Hrebiniak: The other thing here to mention, even though we're focusing on the big companies -- the big US companies -- a lot of dealerships have been going out of business. Have been experiencing financial problems. So if you look at the distribution channel, even if they weather the storm you hve got your distribution channel for at least General Motors and Chrysler being hurt. And, it takes a little while to get that back. If Toyota is still going fairly strong and they have the dealership on the corner selling cars, and the dealership across the street is closed down, it's going to take a little bit to get people with money, financing, backing, to get the distribution channel back where it was. So probably there will be an industry. You're right; the foreign companies are going to remain pretty strong. But I think there's going to be a lot of problems.
MacDuffie: I have just one thought on the dealership issue. You might think that it's easier to close a dealership than it is to close a giant factory. But in fact, each state has franchise laws. And there are a lot of protections against closing dealers. And as the big three have shrunk, they've had a great difficulty reducing their dealerships proportionate to their drop in sales. This then means everyone is competing for the same smaller number of customers. This kind of a crisis puts a lot of dealers out of business. The bright side is, a much more rational dealership structure will emerge.