Last May, Knowledge at Wharton spoke with John Paul MacDuffie, a management professor at Wharton and co-director of the International Motor Vehicle Program, about the state of the auto industry. It seems that not much has changed since then, except maybe for the worse. 2006 was the first year since 1991 that Detroit’s Big Three were all in the red. Ford’s situation seems direr than ever; Chrysler, which was profitable until mid 2006, is now preparing a restructuring plan to roll out this month; and Toyota has claimed the number-two spot in the U.S. auto market, just behind GM. Knowledge at Wharton asked MacDuffie whether he expects any surprises, or new strategies, in 2007.

Knowledge at Wharton: Let me start out with a story I read recently about 2,800 workers at Harley-Davidson Motor Company’s largest assembly plant who were starting a work-stoppage to protest the company’s new wage and benefit plans. The company’s response was that it doesn’t want to find itself “in the same position that the Detroit auto industry is in now” ten years down the road. Has the auto industry become a “poster child” for mismanaged and troubled industries, and is this a fair description?

MacDuffie: I don’t think that it’s a fair characterization of the whole industry. Part of what’s very striking about the auto industry in comparison with industries like steel, which we’ve seen as very troubled in the U.S. in the past, is that there are some very successful companies building cars in the U.S., and there are ones that are really struggling.

I don’t think we’re going to find in ten or twenty years that there’s no auto industry in the U.S. So that’s a difference, and there are some reasons having to do with the nature of the product that seem to guarantee that cars will be built in the U.S., as opposed to them all being built somewhere else and sent here.

Are there some badly managed auto companies? Absolutely. Are some of the issues that they deal with common across other U.S. manufacturing industries? Absolutely. Could better anticipation of particularly some of these labor-related costs have helped? I think also absolutely.

So Harley-Davidson is probably right in trying to deal proactively with some of these things. It’s not a surprise that the Union will resist or want to negotiate the best kind of deal that they can. It often takes a crisis to get dramatic movement on the labor side. 2006, as you have pointed out, was certainly a year of crisis and dramatic changes for both GM and Ford in their labor contracts.

Knowledge at Wharton: That’s interesting. Apart from costs, the more fundamental problem also seems to be sales. If you look at the January numbers for GM, Ford and Chrysler, they just had 50.6% of auto sales in the U.S., while the Asian companies had 42.1%, which is a record high. Do you expect this trend to continue?

MacDuffie: I think that it may continue. It’s been headed in that direction for a while. One thing that made the January numbers stand out is that GM, Ford and Chrysler are trying to break a bad habit of selling a lot of vehicles to the fleets, to the rental car companies. This is a great way to boost your monthly sales numbers, but this conceals perhaps a bit the realities of how appealing your vehicles are to the general public.

So they keep promising to break this habit, and they seem to be doing that, at least right now. That causes these big year-on-year drops. But this shift of market share has been happening. You’re correct in saying Asian companies. It’s not just Japanese; it includes the Koreans, who are doing extremely well in the U.S. So it’s not even a Toyota versus the rest of the industry story. It’s a group of companies doing much better than Detroit’s Big Three.

Knowledge at Wharton: It seems that Ford is in the worst shape as far as the U.S. carmakers go. How did it achieve this distinction, considering that its rivals faced many of the same problems?

MacDuffie: A number of us thought that Ford was the most likely of the Big Three to successfully emulate Toyota and some of the other Japanese competitors. So it is a bit of a puzzle. I think Ford launched a number of product diversification activities, acquiring a bunch of brands, betting that they could put a number of premium brands all together under [sort of] a single roof — Jaguar, Land Rover, Aston Martin and the like — and get synergies from that. Some of those have not paid off particularly well.

They faced probably the most disruptive period of any of the companies during the peak of the Internet bubble, when they had in pretty short succession the Firestone Tire/Ford Explorer controversy, which was massively expensive and massively distracting for them.

And they had, under then-CEO Jacques Nasser, a very ambitious strategy to change their positioning from auto company to consumer services company. This was very much in keeping with the times of new business models. Many people applauded them for being more farsighted than most auto companies. And it collapsed as quickly as the Internet bubble did. Because of the combination of those two things, I think they really never quite recovered.

Knowledge at Wharton: Do you think that there’s a merger on the horizon for Ford?

MacDuffie: Well, it’s hard to see who would actually want to merge with them at this point. I don’t get the sense that’s anything that the new CEO, Alan Mulally, is spending too much time thinking about. Apparently, they did make contact with Carlos Ghosn after his failed effort of an alliance with GM to say, “Well, you know we’re in the same neighborhood if you’re interested.” And I think really neither party needs that kind of distraction right now.

Part of what Ford has done is accept the reality that they’re going to be a much smaller company. They’ve done a very dramatic shrinkage. If they can begin to make the company work at that smaller size, I think they have a chance for a comeback. This is an industry that has big, big crises, and then you look back a couple of years later and companies do bounce back. So, I am usually rather cautious about predicting dramatic disappearances or the like. But Ford is going to be a much smaller company.

Knowledge at Wharton: So even though we saw Daimler-Chrysler being created, I guess we won’t see the creation of Toyota Ford or another company like that.

No, I think the era of the big mergers in the auto industry is over. It’s an industry that’s always had economies of scale, as both its most fundamental rule of economics, but also in terms of managerial mindset that has always loomed very large.

Right now some of the most successful auto companies are small ones that stayed independent. BMW is in a sort of specialty niche, but Honda is very visibly on the more mass-market side. And nobody, certainly not the executives at Daimler and Chrysler, believed that being big is the answer to success in this industry. 

Knowledge at Wharton: Going back to the question of costs, how much do you think these companies’ problems have been caused by their obligation to the unions?

MacDuffie: Well, this is of course part of the historical legacy of the very success of the big U.S. automakers, not only that they had a relationship with unions that goes back a long time, but also that really from the very beginning of the post World War II recovery, they began signing increasingly generous contracts with the unions on both pay and benefits.

And, that [trend] continued to grow up through probably the 1970’s. And then there’s been some steady retrenchment of different kinds ever since then — actually a lot of forgoing of pay by the unions in order to keep benefits. So now, benefits [seem to] get the focus of the attention.

They have competitors that are building cars in the U.S. — paying wages at their assembly plants that are very similar to their own. Those are younger workforces that don’t have anything like the same benefit costs. I’m sympathetic to legacy costs that are higher. I also know that these are not things that are easy to get action on, in the absence of a crisis, as I mentioned a bit earlier.

But I do think that the U.S. industry could have seen this coming — and the Union. And perhaps they could have done a number of things years ago, particularly on the health care cost side. Perhaps, in a way I would criticize the Union’s strategy of allowing all sorts of concessions on pay [and] insisting on protecting every aspect of that health care contract as if it was sacred.

This is because there are a number of gold-plated features [in that contract] that really almost no one in America still has — which now, as they get ripped away, Union members feel that this is a great betrayal. But it is, in a way, an overdue waking up to some of those realities.

Knowledge at Wharton: We were talking earlier this morning about the fact that Michael Dell, who is now coming back in as CEO of Dell, is not going to pay any of his managers bonuses this year. And yet, we also read that Ford is contemplating paying a bonus to its salaried workers, because some of its top management is leaving — even though this promise of a bonus is infuriating the Union workers who claim that they have been giving back millions of dollars to management over the years. Given these circumstances, are the bonuses a good idea?

MacDuffie: It’s a pretty inflammatory act at such a time, certainly. Symbolically, it’s a dilemma to be losing a lot of management talent. In a way, Ford also just had this big buyout plan for its hourly workers. And many more took the buy out, more than they expected. It’s a sign that throughout the ranks, from hourly workers up to management, people are losing faith that Ford is going to come back.

I’m not that confident that bonuses by themselves restore that loyalty and that faith. They may keep some people from walking out the door sooner. Frankly, there aren’t a huge number of alternate employment opportunities right now for Big Three auto executives. So, I think I can imagine better timing for it. Although I’m sympathetic to the dilemmas of a new chief executive who sees some of his most talented people leaving. 

You know the basic problem for GM, Ford and Daimler-Chrysler seems to be that there are various tried and tested ways of either cutting costs or increasing sales. But none of these seem to be working as effectively as they have in the past. And so far, at least Wall Street seems to have been willing to finance Detroit’s losses. Can this continue?

MacDuffie: I think that there are really two things that I would point to that kept the Detroit auto makers from facing up to some of their problems sooner. One is simply the protected niche that they had with SUV’s and trucks for a number of years. This was partly and initially a regulatory loop hole, and they also had the expertise in those categories that their competitors didn’t have. They had a period of time when they had that area to themselves, and these were hugely profitable vehicles.

So, I liken it to a kind of addiction that they really found they couldn’t break. The profits were coming so easily in an area where they had so little competition. And competitors started responding with very competitive products, but also energy prices [increased] and consumer tastes shifted away from those large vehicles. They really weren’t ready with a contingency plan. It’s fine to sell vehicles where you have an advantage and you have a high profit margin, but be ready for other things.

All of the incentives that they were placing on the other vehicles to move them, to achieve certain economies of scale, to keep their factories operating at certain levels — there was a sense that volume would solve most everything. It would certainly buy them time for the next wave of fantastic products that they were telling themselves would win over consumers.

I think that is also a kind of addiction that’s hard to break. And of course you train consumers to expect you to pay them to take your vehicles. And over time that weakens the brand. It distorts all of your sales and marketing activities. They have found it to be a very hard habit to break, because every time they have announced “we’re going to stop doing this,” they have a terrible period of sales, their dealers start screaming, Wall Street is concerned, and they usually have introduced another round of some kind of sale or rebate.

So I’ve become a little bit skeptical when I hear the announcements that they’re going to break away from this. Once they are through this period of quite drastic downsizing, it should be both easier and more natural for them in fact to sell less to match their now reduced production footprint. I think the sooner they get to that, the better.

Knowledge at Wharton: I don’t mean to keep picking on Ford, but Ford has said that they expect to make a profit in 2009. And I guess the question is how realistic is even that projection? Is it based on any concrete facts, or is it just this hope that their strategy of downsizing, etc., will pay off?

MacDuffie: Well, I haven’t seen the detailed numbers that they’re using. I’m sure that they have had to show numbers to Wall Street and other analysts, certainly to their creditors. They’ve borrowed a tremendous amount of money in order to invest in new product.

The one other big turnaround that’s in everybody’s memory is the Renault- Nissan alliance. And part of what Carlos Ghosn did at Nissan was generate a huge amount of capital, partly by selling off equity stakes in suppliers, but [also] using that for a massive surge of new product. And, that was successful.

And if Ford can get some product before the public that people find exciting and match that with their now trimmed-down cost structure…. They’re going to have all of this debt to pay off, which is what makes any specific year projection a little bit hard to assess. You know, Nissan-Renault had, it turned out, some wonderful synergies in terms of producing those new products with a combination of Nissan’s very strong engineering and some of Renault’s styling flair.

What does Ford have that they’ll be able to bring anew to their product portfolio, from this surge on product, at a time when they have lost some of their product engineers and the like? That is, I think, the biggest risk.

Knowledge at Wharton: Speaking of Ford, let’s imagine for a moment that Alan Mulally, the CEO, were in this room with us. What’s the one piece of advice that you’d like to give him?

MacDuffie: Well, maybe I’d give him two, if you’d allow me. I think one that’s more internal and one that’s more external. On the internal side, I would warn him — and he may not need to be warned — that the loss of a massive number of experienced employees from their factories and many other parts of their organization is something to be careful about. This is because even with good new products, they could suddenly hit terrible quality problems or terrible problems with meeting the dates of their project launches … or tackling operational things that people expect in this industry — [so] it could all be undercut. They have a brief window to reestablish themselves, and they’ve lost a wealth of organizational knowledge and that’s a risk.

As for the external side, the product side, Ford has certainly been advertising and talking about trying to rebuild the image of the “American Muscle Car.” Certainly that is something people associate with Ford. I think the way that the car product market has gone, there are niche products that get you some buzz and some excitement.

But we’ve seen now in many different cases the affect really doesn’t last that long. So, they could actually be very successful at doing that, but it wouldn’t help them because they really need to be selling large numbers of the more bread-and-butter cars.

There’s another part of Ford’s history which is, I think, more reflected a bit in the fact that Ford employees still call the company Ford’s. It’s a family company. It has a long sense of connection to American history, and many people owned Fords, not because they were muscle cars but because they were reliable family transportation that felt like part of America. If they can reestablish that link in more of the core of their product line, I think that’ll help them more than reviving the muscle car image.

Knowledge at Wharton: I just wanted to mention Toyota, which could surpass GM this year to become the world’s largest automaker by production. Sales went up 10%, Ford’s dropped 19%, and GM’s dropped 16%. What are the implications of Toyota’s muscle for this industry?

MacDuffie: Well, everybody has been watching carefully for that moment when Toyota will be number one. It’s been an inexorable trend in that direction. So it will happen, and I don’t think the exact timing of it matters to anyone all that much, except for perhaps the press coverage. There are some bragging rights with it.

GM has indicated that they’re not going to yield the position of number one easily. But, Toyota’s momentum is tremendous. They continue to set the benchmarks in the industry in many ways. They’ve had a few problems, of late [which were given a lot of coverage] — and very consistent with their approach, they’re very, intensively focused on those problems.

Toyota has had some quality problems; they’ve had some extensive recalls. They worry that they may be growing too fast and may be introducing new products too quickly, or the product life cycle may have gotten too short. So, we shouldn’t assume that every trend up until now will continue without any deviation — you know, that Ford and GM will continue to do badly and Toyota will continue always to do better and better.

Hyundai is another company that’s been doing extremely well. But due to both currency fluctuations and also other things that Hyundai has done to improve their quality, their costs are rising. So we may have this unexpected situation where Hyundai begins to be constrained by the fact that their costs are getting too high, while Toyota begins to get into some difficulties because of quality problems. This is not what we would have expected a few years ago.

So, again the ability to be resilient, to learn, to recover from adversity whatever it is, is going to continue to be absolutely critical. Toyota has an extremely strong track record of being very good at that. And I know from their internal culture, they don’t spend a lot of time patting themselves on the back about how great it is that they’re number one. They’re very self critical about all of the flaws that they see. That gives me some confidence that they’ll continue, maybe not without some bumps, to be the strongest in the industry.

Knowledge at Wharton: I have one last question for you. We talked about Toyota and the Korean car companies. China has been saying that they want to start selling cars in the U.S. And, lately some Indian companies, notably Mahindra and the Tatas have also been making similar moves. Do you see any unanticipated competition coming from either China or India that could change the balance of the U.S. auto market?

MacDuffie: Well, the entrance of Chinese and Indian car companies into the world industry picture is, I think, already making a difference. How much impact it will have in the U.S. market, in the short term, I’m not so sure. I think the greatest opportunities for both the new Chinese and Indian companies will come in domestic sales. And the opportunities for grabbing part of that tremendous growth are very high for them.

It’s much more difficult to break into the U.S. market. It’s a great symbolic goal and sign of achievement … if you can sell your cars in the U.S., the toughest market in the world. But in the short term, I think the opportunities domestically are so high that it makes sense for them to put their energy there. Also, all of the multi-nationals are in there trying to grab that, too. So if they neglect their home market, they may lose some ground.

That said, I think if the established automakers neglect areas that U.S. consumers show they’re very interested in, such as very low-cost — say, under $10,000 — vehicles, that creates an opening that the Chinese would be very pleased to fill. And of course, they may show up first — not under their own brand names, even though they would dearly love to do that, but in producing vehicles for someone else to sell.

And, already Chrysler has made much of the fact that they are looking for a Chinese partner to build a car, a Chrysler that they can sell in that very low-cost range. So that would be my bet. Looking at the history of the Koreans, the most recent country to really rise to prominence, I think China, India, and any new entrant will have to meet the quality expectations of American consumers.

That’s not going to be a fast process for anybody. Maybe the Chinese and Indian new entrants will achieve these quality standards more quickly than the Koreans did, but it will take them some time. And they can use their domestic market as more of a testing and learning ground for making those quality improvements, because in the short term their home market consumers won’t be quite as demanding as U.S. consumers are.