Friday, 29 August 2008

Company Focus – Chrysler LLC – Snakes & Lazards: Seeking a New Den for Viper.

When Chrysler was being structurally re-modelled in the late 80s, it took an innovative stance with then new 'cab-forward' vehicles that were decidedly progressive vs GM's traditional, boxy cars and Ford's organically shaped, yet conventionally proportioned offerings.

'Cab-forward' was almost a metaphore for a radically forward-looking company, and as part of that ambition, 1989 witnessed Bob Lutz's re-creation of the spritually lost 'All American Sportscar'. It came in the shape of the Viper, the prototype shown at Detroit's NAAS that year. A new nameplate (with obvious snake derived links to Shelby's Cobra) for an all new low volume production premium priced sportscar. Viper was to have a 'halo-effect' for Dodge, recapturing the past glories of muscle-car names like Charger and Challenger, and adding kudos to the SRT performance division.

16 years on and Chrysler is in a very different position to its upward lift of the 1990s. It has ridden the economic wave of the 90s and early 2000s, having exploited more than any of the Big 3 the trend for and subsequent reliance upon what were high margin trucks and SUVs. But changing times and a flat economy have put Chrysler back at the bottom of the trough of the US industry's historically normative heavy cyclicity

So today, in the $4 per gallon era, as part of Cerberus' Project Genesis, Chrysler's management is undergoing a $1bn revenue raising exercise through “non-core” asset disposals, $500m of which has thus been achieved with sale of the Californian design centre to Daimler and a Brazilian engine plant to FIAT. And at a time where pertinent alliances such as those with Chery for small cars, Nissan for compact car and possibly FIAT for joint US production, Nardelli and La Sorda has rightly recognised that Dodge's dedicated, small-scale sportscar business is a management and fiscal distraction that should be sold. Hence Chrysler seniors are (possibly) euphemistically “listening” to potential suitors for Viper – the cars, the brand and perhaps the Conner Avenue production facility.

It could be said the financial PR machine is underway, Lazard's appointment will have undoubtedly prompted their own PR consultants to spread the word to generate external stimuli in the press and interest, Chrysler's apparent “come hither” stance part and parcel of the inducement process.

But to the crux of the debate and who exactly are the suitors for the Viper business?

The financial press' (Bloomberg etc's) first thoughts were of a trade buyer, an industry expert identifying Shelby, Panoz and Saleen. But whilst we come to these (top of the tree entities) further down, the majority of the US specialist trade posses non too surprising similarities which from vital perspectives of operational realities are not immediately viewed as overtly synergistic:

- Parental Backing/ Ownership -
often family business, small PE group, regional small bank or a division of a larger regional industrial entity that specialises in metal and composite fabrication.
[Viper was born from large VM capabilities and supported as a strategic pet project, thus may have not been ever truly exposed to realities of external funding assessment and independent, self-support. And Viper's current management may endeavour to stay with Chrysler as opposed to running the business on far smaller budgets and with closer owner / director examination}.

- Product Type -
Majority simply not up to Viper (ie large VM) Quality Standards, whether: styling sophistication (often limited due to less sophisticated forming techniques), engineering robustness (due to limited design, testing, re-engineering process) and feature content (due to incurred product build cost and lack of technology supplier relationships given low volumes)
[The internal styling, engineering, feature & quality demands to keep Viper at its current level, let alone improvements required to reach benchmark standards, may well stretch beyond the true competencies of other apparent 'peers']

- Brand Positioning
Most specialist sportscars seen as playboy's toys catering to finite scale sub-segments, seen as credible in that segment given product differentiation or purity, but not credible in mainstream
[Viper sits as a credible car due to its parentage, and as such sits in a rare middle-ground between the plethora of lower quality (often quirky) vehicles and the premium territory occupied by the likes of renowned Italian & British marques. This is a very lightly populated field by 'specialists' given that the predominance of $80-90K sportscars are from mainstream VMs and matured 'fully fledged' luxury sportscar companies].

- Technical Resources / Dependencies
Predominantly production orientated with no or little in-house development engineering capabilities. If a divisional part of a larger industrials holding company reliant upon sister relationships. New developments occur with injections of fresh capital usually via change of ownership.
[Viper was developed at a time of substantial corporate backing – Fed loans etc – and utilised much of Chrysler's large development resources to deliver a standard. Chrysler has kept Viper on par with legal requirements (ie emissions compliance of the all alloy V10 engine etc) but as Chrysler's own 'shape' changes will it actually deliver the levels of technical support present warm comments imply? NB this especially so for the now old V10 engine, the heart of the car].

- Procurement Leverage
Small scale purchase levels mean victims of being 'price takers not price makers'. No or limited relationships with advanced technology suppliers, having to lack feature and if needs be often source expensively through motor factor companies, not directly from disinterested suppliers..
[Viper is essentially a product of the Chrysler machine, its parts bin and a large “understanding”supplier base that assisted on Viper to maintain the customer relationship]

- Labour Costs
Critically must be maintained at low level and flexible compared to UAW or other semi-skilled standards, since the low volume business model relies on sizable labour, thus labour & variable input costs must be constrained to maintain viable profitability.
[Hardline labour negotiations would need to be undertaken with the Viper plant staff – if indeed the facility and same staff were retained - which although now excluded from renewed UAW agreed contracts will be required to swallow hard at reduction of pay and benefits]

- Distribution Networks
Low volume producers of specialist product have very limited,
often regionally based prime network of independent sales sites, which if have a better recognised name, is assisted by a further second tier of independent sales sites in other states / regions. The majority of sales are made from the factory's own showroom, with dealers typically displaying a makers car amongst other, alternative branded vehicles.
[Chrysler obviously has enjoyed the benefits of a massive dealer-base, who themselves have enjoyed the margins on Viper but also, for some less well located sites, somewhat cajoled. That broad national spread of dealers has been a major factor in both accessing the nationwide customer base and instilling confidence given Chrysler's credentials]

- Service Networks
Typically a specialist producer will have sold cars return to its factory for servicing and repair. Although the cars tend to be simple enough for 'mom & pop” garages to service, and could theoretically be done anywhere, the factory relationship is part of the car's ownership experience for the client and a factory stamped logbook for service & repair greatly assists vehicle residual values, keenly sought by pedantic follow-on buyers.
[Given Viper's parts bin basis, it is serviceable at any Chrysler approved, and other, garages; that was part of the car's appeal. But again, the size of the Chrysler service network plays a major role not typically accessible by a specialist producer. Agreements could be put in place but would they be honoured, especially by the independent garages of Chrysler service network?]

Those synergies would have to be primarily product and facility based, and whilst idealistically each of the smaller suitors would love to ride on the back of Viper's Chrysler connections to broaden its own nameplate, first thought impressions are that trying to grow through such an M&A would be very problematic, leaving both of the suitors caught in an operational middle-ground, a no-man's land.

Bloomberg's exploratory calls to Shelby, Panoz and Saleen – Viper's apparent low volume sportcar peers – demonstrate that they may not really, as of today, in the running. And that shouldn't be surprising.

Although perceptionally top of the tree and well positioned, appearances can be deceptive. Whilst are indeed those companies operate in the US niche sportscar sector they are in a very different, much smaller, less capable league in terms of financing and management scale.
investment-auto-motives is not overtly familiar with Panoz and Saleen in-house operations but had the pleasure of plant familiarisation at Shelby (nee Shelby American) in 2003.

As for 'match'?...

There's no need to give a potted history of Shelby, it's self-evident, but its evolutional business model, mow listed on NASDAQ (Caroll Shelby International) has fundamentally been as follows:
a) the in-house production of the limited edition specials of the authentic Cobra and other less successful 'update' ventures such as the Series 1 and 2.
b) the in-house production of enhanced VM product (notably Mustang GT's, GT-R's and KR's) now re-applied on modern Mustangs for the 2006 GT-H and 2007 GT500
c) the licensing of the Shelby name for use on VM produced cars (such as 70's Mustangs and 80's Chrysler product)
Las Vegas based Shelby Automotive has a spiritual link to Viper given that Carol Shelby has had project involvement from the car's inception and it has worn Shelby blue and white colours from early on and again as special edition homage colours in 2006 (GTS Blue). Thus the connection and lineage is apparent and has been used in Viper's marketing from the beginning. Shelby has not (to date) put his name on Viper though it is a possibility. As for buying the Viper business, evidence of past commercial behavior of minimal build involvement and maximum brand exploitation seems to preclude that likelihood. Although the business may have changed since our visit, at the time it was running lean in management and staff using the inmates of a local penitentiary to produce the panels for Cobra – the very essence of a low cost labour policy, and well away from Michigan's labour expectancies. Shelby (man and company) is a wiley ol' bird and would know every nook and cranny of the Viper business. As to whether the company would take on the commercial realities of an aged Viper vehicle and its accordant operational and commercial responsibilities...probably not.

Looking to its latterday spiritual successor and Irvine CA based Saleen operates as both a provider of performance enhanced special editions (of Ford Mustang and F-150) and S7 mid-engined supercar derived from racing. Its Ford links go back to 1983 when race-driver Steve Saleen started producing special edition Fords (much in the mould of Shelby in the 1960s). By 2003 links had grown string enough to use Saleen as a nominated supplier / assembler for the Ford GT supercar programme. To enable that Saleen opened a 200,000 sq ft facility in Troy Michigan which latterly created the Mustang GT-R. Thus would such company with such 25 year old Ford association and its own 'new' Michigan facility that can engineer a Ford based architecture from scratch be interested in buying what is effectively an updated 16 year old car (based on possibly defunct components) aswell as a second site at Conner Avenue? We think not.

South East of Las Vegas and Irvine in Hoschton Georgia we find Panoz Auto Developments, founded in 1989 by the father son duo Don & Dan Panoz. Along with its sister company to Panoz Motorsports Group, which in turn owns single seater constructors Van Dieman and G-Force, aswell as 3 racetracks in Ontario, Georgia and Florida (the renowned Sebring) held under the holding company titled Elan Motorsport Technologies. Panoz has produced 2 road cars: the Roadster, the Esperante in many variants used for road and SCCA racetrack, and most recently developing the Abruzzi. Race cars are LMP series developed for the American Le Mans 24 hour events that Panoz itself promoted. Perhaps most interestingly has been the development of the Hybrid car along with Zytec Engineering of the UK, giving Panoz a lead in designing for Green Racing. Like Saleen, Panoz has been historically linked with Ford for supply of Mustang powertrain and gearboxes, though these base units have been developed in due course. Keen to build truly independent Panoz designed vehicles it seems unlikely that the father & son duo would want to bring the Viper into their fold. Indeed as a competitor on the SCCA track the decline of the Viper would be all too welcome so as to effectively aid GT motorsport and American Sportscar retail ambitions.

Beyond the strategic corporate fit, of which there seems little at Shelby, Saleen and Panoz, there would need to be an ideally natural technical fit, by which we mean that platform dimensions (known as engineering hardpoints) should be similar so as to simply require re-skins and re-fits to produce 2 differently branded cars from one platform. Whilst there is a general construction similarity between Viper and Panoz (ie generic spaceframe & composite panelled exterior) this solution is the basis of many specialist builders – the global norm. Hardpoint dimensions of wheelbase, front/rear track, front bulkhead etc are very different – eg Viper W/B @ 98.8 inches vs Panoz W/B @ 106 inches.

Hennessy Performance Engineering of Houston Texas is perhaps most familiar with Viper as it produces the Hennessy Venom variant which has structural, suspension and powertrain enhancements. However, whilst Hennessy has a dedicated Viper section it also caters for a complete spectrum of manufacturers' vehicles, its raison d'etre being a broad spread to avoid 'all eggs in one basket' syndrome that many 'hot shops' have suffered from in the past. Hence its set-up and management capability wouldn't mirror the demands of running the comparatively massive Viper business.

So as stated, the 3 'top of the tree' suitors and latter 4th possibility are not immediately obvious cohorts unless the their respective finances and business models took a major change of direction.

They are some of the 187 small vehicle makers in the US today, and to put them and the Viper division in perspective investment-auto-motives demonstrates the structure of the industry & market using a 3 tiered model, highlighting Viper to be in the lightly populated middle-ground:

Level 1 – 'The Royals' (2000-4000 vol pa) – Ferrari, Lamborghini, Aston Martin etc
Level 2 – 'The Aspirants' (200-2000 vol pa) – Viper, Lotus, (TVR) etc
Level 3 – 'The Idealists' (20 – 200 vol pa) – the USA's 187 specialist car companies.

This landscape differentiates based upon 3 core criteria, though ultimately inter-connected:

a) Core Competence (Specialisation)
b) Brand Reputation (Price & Position)
c) Operational Leverage (Auto-Industry Relations)

Of the 187 bottom tier 'Idealists' (often backed by dream-fulfilling, legacy seeking business people like the Panoz family) the broad spectrum of builder can be sub-segmented into 18 distinct groups; each described by product genre and entity strengths. Thus investment-auto-motives has created broad-view picture of the A-Z builders, from American Street Rod to Van Genaddi and beyond.

Our exploration highlights the fact that for many businesses seeking to make a name in the sportscar world with reduced costs, reduced complexity and improved quality the obvious answer is to utilise a borrowed platform. The preferred solution is unsurprisingly Corvette, the ongoing king of mainstream US sportscars, and so providing a reliable low cost base, since 1953. Borrowing a platform obviously has its drawbacks in terms of creating a bespoke car, it will not have extreme performance parameters, but for many like Anteros and Dragon having much of the technical development (eg emissions & crash compliance) done is a major advantage, and so the pragmatic route forward.

Ideally Viper could offer a similar 'packaged solution' for present and new builders, but GM's and Corvette's relative stability vs Chrysler's and Viper's relative instability does not bode well, unless a radical step was taken by a lobbying specialist sector for government assistance in developing Viper as a new specialist platform alternative...a very unlikely outcome.

Given present conditions, investment-auto-motives posits the following scenarios based on likelihood & impact rated out of 10:

Scenario A : USA Sportscars Inc
Least Likely (2) – High Impact (8)
Under a newly announced government review of the US Auto-Sector, set-up as part of the far-reaching Energy Bill, the government sets aside funds to develop USA Niche Sportscar industrial competance. Done so utilising the Viper business, Chrysler and its Detroit peers as the cornerstone to developing the abilities of regional small-scale builders nationwide, to aid the growth of names like Shelby, Saleen, Panoz etc as worldclass vehicle constructors in their own right.

Scenario B: USA Trade Sale
Low Likelihood (3) – Mid Impact (5)
New developments that counter the aforementioned rationale for pessimism create a game-changing outcome. A hard-hitting big player backs a small name producer to buy Viper and develop 2 US nameplates in tandem, or an ambitious Supplier company acquires the business in order to demonstrate and create its own Tier 0.5 ambitions.
The present lack of liquidity in the banking sector would negate the investment community backing such as daring move, unless paralleled by Scenario A developments.

Scenario C: Private Equity Sale for Latter-Day Asian Disposal.
Mid Likelihood (6) – Low Impact (4)
A large PE firm, or more likely consortium, buys Viper from Chrysler (Cerberus) and looks to gain maximum value extraction by courting Asian (ie Chinese or Indian) players who seek an iconic brand for their growing international portfolio. The current plant and equipment in Conner Ave would be relocated to a new overseas production site enabling far lower cost achievement in what is a labour-intensive vehicle. The Michigan site would be used to create a US base for said company to fit their US growth strategy, possibly starting with a latter-day sportscar build using Asian sourced components.

As events stand investment-auto-motives believes Scenario C the most probable, given Cerberus' & Chrysler's time pressures and the impetus for Lazard to find a new parent that can maximise the value extraction from Viper Cars.

Tuesday, 26 August 2008

Macro Level Trends – Industry Realpolitik – America Auto's SOS

As North American Automakers steel themselves during these watershed times and orchestrate strategic change through smaller vehicles and propulsion ancillaries, they look to the Senate and Congress to assist through these difficult waters. Hence reports of Detroit and the 'New Americans' (From Toyota to Hyundai) calling to draw upon the initial $3.75 billion of the alloted $25 billion from last year's Energy Bill that seeks to serve the auto-industry in changing its ways.

But as the governmental affairs people of any car-maker knows, all too often the rhetoric that is postulated on the floor all too easily turns into lip-service and decreased budget spend. Hence the push to begin to access those funds as soon as possible, to firstly ensure its acquisition and secondly, continue to lobby for additional $25 billion funds as the more socially spendthrift Democrats come to power. The timely call for assistance coming as GM & Ford combined lost $24.1 billion in Q208.

Obama has of course been leading the torch of energy change and even at one stage muted, though not confirmed, that $150 billion may be the required sum to re-organise the auto-sector to meet the challenges of this very different century. The foundation vehicle to that better tomorrow exists in the guise of 'Renewable Energy' and the 'Renewable Portfolio Standard' to include: nuclear generation, carbon capture and sequestration, energy efficiency and demand response programs.

The 2007 US Energy Bill set the cornerstones of both social and industrial understanding and the range of legislative 'weaponry' that would be rolled out. This year, amongst the plethora of issues raised by Congressmen to be included as Amendments to the Energy Bill, we see proposals that span a multitude of areas, the following providing only a flavour of this massively wide-reaching piece of historic public legislature:

a) declined Virginia's Governor to explore off-shore drilling
b) alternative energy capture via methods such as geothermal extraction
c) creation of national ocean energy research centres
d) active co-ordination of nano-science centres and IPR 'first calls'
e) et al

Importantly, the Proposed Ammendments to the US Senate Energy Bill heard between the 12-19th June 2008 that have direct influence on auto-industry direction, budget and behavior are as follows:

- SA 1527 *Extension of tariffs on imported ethanol to 2010
- SA 1532 *Fast-track (180 day approval) of higher blend ethanol (over 85% ethonaol) [Thune]
- SA 1534/65*Biofuels Investment Trust Fund
- SA 1543 *GEM Flex-Fuel Vehicles – expands definition to include M85 (85% methanol)
[Bayh, Brownback, Lieberman, Coleman, Salazar]
- SA 1558 *Healthcare for Hybrids – 10% re-imbursement to automakers on retiree costs in return that at least 50% is put toward fuel-efficient initiatives (R&D, production development, worker re-training) [Obama]
- SA 1563 *E85 Support for Retail Gas Stations
[Dorgan, Craig, Kerry]
- SA 1711 *Alternative CAFE Proposals (more lenient) – [Levin vs Bond positions]
- SA 1752 *Electric Drive Transportation Programme - Promotes the development of 'plug-in' electric vehicles, deploying near term programmes to electrify the transportation sector, and including electric drive vehicles in the fleet purchasing programs
[Salazar, Bayh, Brownback, Lieberman, Coleman, Cantwell, Lincoln, Clinton, Biden, Klobucher, Durban]

Ultimately realistic goals appear to be the driving force. The SA 1538 Clean Portfolio Standard which sought to 'stretch' the clean energy percentage mix attainment (of the SA 1537 Renewable Portfolio Standard from 2010 to 2030) was tabled, probably in the belief that it would be unattainable and cause industrial disruption in endeavouring to do so.

Interestingly, the SA 1546 proposal by DeMint “limitations on legislation that would drive up the cost of auto-fuel” was retracted or rejected. This could be construed to be a salutary political ploy (& play) to demonstrate Congress' dedication to the green cause; highlighting the willingness to cross traditional energy related boundaries born from social taboos (ie a high gas price). But of course we suspect there was a none too small aspect of political showboating behind the 'one-man-crusade' proposal. It was not exactly well backed, in the way that many of the directly auto-related issues were. Given the lack of names registered forwarding, seconding and thirding the motion proposal, we assume it to be a a rhetorical display and although passed, the wording very probably lightweight and tenuous.

On the surface, the same seems true of a possible disengenuous proposition to disallow the combined co-processing of renewable diesel and petroleum – SA 1800 [Kyl].

But perhaps the most absorbing motion was for that of the 'Gas Price Act' [Inhof & Thune] which whilst including some useful inititaives also included ideas for Indian Reserve land exploration – a very sensitive topic. So for all the apparent 'do-gooding' was undermined by the inclusion of a 'political bomb' that blew the motion out of the water; defeated by 52 to 43. Another case of staged dramatics, and outcomes, it seems.

However, the 'Sense of Congress Act' (requiring 25% renewable energy by 2025) seemed to answer the call set out by Al Gore's long standing, globe trotting 'Inconvenient Truth' campaign. The views of US politicians and their voters have gradually aligned to the 'awakening'. Whether ultimately scientifically proven or not – the detractors still there but increasingly marginalised – the politicos in DC have recognised that 'saving the planet' is a massive force for economic change, and one that is more easily embraced by the populous as the possible hardships of said change takes effect. As such the usual divisions in the ranks between Republicans & Democrats have been closed, an aligning of understanding and interests illustrating that the merits of major issues are not to be debated, instead the goals to be reached and the roadmap forward to do so.
This then bodes very well indeed for the American auto-industry and its case for sizable fund appropriation.

In its current deflated and weak state it will need major Federal assistance to properly get back on its feet. Yes the major problems such as the massive pensions and healthcare legacy costs are being transferred off of balance sheets and into UAW VEBAs, and as such will lighten the fiscal load on the Big 3. But even with this depleted baggage present-day headwinds such as experienced cost-push inflation of input prices, the concerns of possible longer-term stagnant Western markets, slowing Asian demand and the size of the international competition gap (esp against Asians) remains daunting.

Thus seniors in Detroit (and those in Wall Street should) well recognise that a weighty argument for hefty loans &/or grant subsidy, with reduced usage clauses, can be presented. Indeed, from the perfect storm of events, suggests that there has never been a better time for arguing the case.

But Detroit and its 'New American' cousins may need more than what might be seen as over-played Michigan-centric gambits to state its case. Even with the high number auto-empathetic Congressman (from Bayh to Salazar – see aforementioned list), or perhaps because of, investment-auto-motives believes that Washington may well call for an independent review, following on in the footsteps of similar exercises in Australia and, currently, the UK.

A US Auto-Industry Review would put metered argument into the debate and ensure a resultant balanced, far sighted and monitored process by which the much needed monies and off-sets - presently argued at a value of $50 billion but possibly rising to Obama's $150 billion - could be deployed in fundamentally re-shaping the sector. Old names like Detroit Diesel and Detroit Electric possibly reborn whilst southern states and newer players receive their quotient too. A full industry review born from fully understanding the cost to align Auto and Energy will we suspect bring forth a world of investment opportunity that both the VMs and industry backers.

For bond-buyers (and their brokers) such governmental involvement adds long-term security which will be evident in the re-rating of the Big 3 and so in due course promising to lift out of “junk”/High Yield territory. The present day short-termist bond-holders enjoying higher returns and no doubt holding default policies will be replaced by a greater field of institutionals who seek the safe plod of lower yield.

For stock-buyers the upside comes in two forms: the near and the long. Near term 'value-based' early buyers will see an intermediate upsurge in auto-stocks as confidence is injected back into the market, whilst once back on its feet and healthier the sector will attract 'growth-based' buyers.

These 2 groups short and long play groups would generally be characterised as private money vs public money.

As value-based seekers Private Equity and Hedge Funds buying into the sector via publicly traded stock would look to see this PIPE (Public Investment of Private Equity) as a natural follow-on strategy to their previous and current privately held auto-sector acquisitions. Acquisitions that were bought and turned-around to be held if warranted or sold off onto the listed public markets if they held greater ROI potential than trade buyers (who besides cash-rich family owned entities look thin on the ground right now).

And of course once the auto-industry, its players, their volatile valuations and public markets have stabilised, in a more confident national and global economic climate, the big Fund players will appreciate the long-term value growth that Autos brings as it has demonstrated itself to have pulled through the present, and dark, long-cycle trough.

But as Wall Street knows, the key element to the start of that upturn is government's appreciation of the systemic rewards that its own investment in the US auto-industry will bring.

To ascertain the investment levels demanded for the sector's re-structuring will take a full and comprehensive review, which given the global span of the Big 3 and the likes of Toyota, in turn will have relativity to Australia and the UK - and their own respective investment possibilities.
So Congress must understand the consequences of its actions as it seeks to appreciate the profoundness of its benefactor role.

Monday, 18 August 2008

Industry Structure – German Supplier Sector – Continental & Schaeffler: Deutschland's Doing?

The German supplier sector has found itself under increasing pressure to evolve and compete as the rapidly shifting structural sands of the global supply network encompasses 'bottom-up' consolidation and retirement for North American firms to 'top-down' quality learning and expansion for Asian firms.

Caught in the middle-ground is Europe, none perhaps more exposed than Germany, a country that has built its second-half 20th century economic success on the back of superior, world-class engineering and technology. But the end of the 20th and beginning of 21st centuries have seen the quality chasm shrink as industrial education, development technology are adopted to nurture global-wide regional skills-bases.

As the supply-base at large treads a production path to the Near and Far East, chasing lower production costs and growing local markets - as we've seen with VM's - the centre of gravity moves East and the raison d'etre to create localised R&D and new product development centres grows. Renault, GM, Hyundai et al have been the arbiters of change and are persuading their suppliers to locally support. Most recently with the announced PSA-Mitsubishi green-field production plant venture in Russia's Kaluga area. (Since the noted success of Daimler's groundbreaking supplier-vested Smart build hub all VM's have lobbied for close-proximity supply to reduce logistics complexity and costs and maintain the production quality dialogue).
This trend comes at a time when the very fundamentals of supply-sector economics is being challenged as Eastern suppliers, with or without Western JV assistance, are able to design and deliver a plethora of 'low-value' components, primarily with metals casting & machining, metal fabrication and rubber products. That has fragmented the production bases of 'low', 'mid' and 'high-value' components engineering and production.

The problem for Germany is that the post-WW2 industrial policy that melded a socialist-market-economy mentality with the ambition of self-sufficiency – most notably evident at VW's Wolfsburg - which underpinned German industrial strength started to become its undoing when set against the modern globalised context that emerged in the 1990s. The German consensus between labour corporations and government – the sozialmarktwerkshaft – had for decades given high salaries to induce high productivity, backed by large public investments in education & training and governed by powerful legislation and regulation, especially so in labour contracts so as to create and spread wealth. Along with a monetary policy that maintained low inflation and a strong D-mark.

However, as Japan rose as an economic powerhouse, and the rest of Asia threatened – ultimately delayed by the 1998 Asian Crash - the Bundersbank, politicians such as Gerhard Schroder and think-tanks such as the Friedrich Ebert Foundation realised that Germany was becoming increasingly isolated from not just its more flexible, low cost European neighbours, but seriously disjointed from the rest of the world; and so perhaps at greatest risk of future economic shock.

The 'Wirtschaftswunder' (economic miracle from the 1950s-90s) was recognised to be redundant.

As a consequence German industry instigated what were seen to be radical reactionary reforms as European Integration and the beginning of Globalisation took hold, the competition gap in traditional industries such as coal, steel and engineering grew as a result and German unemployment swelled. Companies like Bayer, Hoescht and VolksWagen had to make their voices more loudly heard both on the public stage and within the halls of power, and did so.
A major driving force of that period was the auto-sector, underpinning the major export pillar that had started with the trickle of VW Beetles in the early years and led to conquering the world in the premium sector by the 90s; not forgetting the importance of trucks and of course auto-parts.

The breadth of automotive technology has grown immensely over the last 2 decades, the Germans and Japanese the major proponents and purveyers of that trend. As part of its long-held self-sufficiency ethos the German supplier-base expanded to maintain 'whole vehicle' capability; spanning from Basic Bearings (as we shall see with Schaeffler) to Bluetooth Telematics (Continental). But of course the sector consisted of many many privately-owned and publicly owned enterprises and it has been the progressive, forward thinking firms like Robert Bosch that actively encouraged the technical stretch, recognising that its USP lay in tomorrow's world (as large German tech traditionally had, from Braun to Siemans etc) and as a large international entity could see the world changing at first hand.

That ongoing learning duly permeated the German government, and whilst there has historically been a very close 'socialist' knit between government and industry (as seen by the existence of Supervisory Boards with nigh-on 50 year worker representation), the rate and impact of global change, compounded by demanding capital markets and massive inter-regional investment flows, meant that Germany needed to adapt and reform industrial outlook and policy. (That was 'assisted' by the influx of cheaper labour made available in 1989 with the fall of the Berlin Wall, that assisted in reducing part of the input cost equation). For the big German conglomerates like Bosch and Continental, already international in scale and operations, the changing governmental stance has been part of day to day business, indeed they helped drive it, but for the smaller concerns with domestic-centric operations the change has been daunting.

We stipulate 'daunting' because a higher proportion of German firms have been historically, and still are, family owned. (95% of Germany's 3m businesses are family controlled). Fortunately within industrial engineering they have enjoyed little strategic disruption on the back of an ever growing German automotive and engineered products demand. General business acumen and inter-family association has witnessed collaborations and takeovers in each industrial products segment; especially during economic downturns or hiatuses. But in essence, the smaller and mid-size firms (like Schaeffler) were essentially living in a protected, stable, insular eco-system that did not encourage the evolutional development experienced by more exposed firms in say the US, UK or Japan – the voracity of competition exposure was simply not as high.

But the last few years have seen the results of 'reformation trickle-down' from big corps back in the 1990s. Ten years on industrial re-alignment has start to take shape as the mid-large size enterprises within Deutschland GmbH. Companies that lived off of yesteryear glory days and often held back by traditionalist family power, have been forced to understand their individual industrial positions, thus broader national appreciation and latterly international management thinking have emerged.

This well exemplified by Schaeffler's acquisitions of LUK, INA & FAG in attempt to become a major concentrated national player with international reach across all continents. Broadening its product portfolio, increasing individual (Auto, Ind, Aero) sector & sub-segment market shares, generating economies of scale greatly needed to combat energy & materials input costs and reducing general sales & administration overhead. But critically, as Geissinger knew, the move was to avoid being trapped in the highly competitive, low-barrier entry, arena of precision bearings. In summary,the M&As have broadened the portfolio to include:

a) Schaeffler's,INA's, FAG's overlapping & complimentary bearings range (P/T & wheel hubs)
b)LUK's clutch & gearbox components
c) Schaeffler's & INA's engine (timing & drive) systems components

But as the growing company's dynamic CEO Jurgen Geissinger well knows Schaeffler Group is still an industrial minnow when it comes to vying on the world-stage, and he's recognised that heavy reliance in a few pockets is untenable, made all the more evident this month with European car sales down 8% this month, and US premium car sales heavily contracted, hitting the German premium brands hard, who in turn will be adding additional efforts in major procurement cost savings on low-value parts; in turn squeezing Schaeffler.

Hence his unsurprising strategy to strengthen the core bearings business via M&A of German peers and then to look at Schaeffler re-positioning itself as an industrial powerhouse far further up the value chain into sustainable, higher margin electrical and electronic systems territories. The latest of which are technologies like Lithium-Ion battery development & production and Intelligent Network Telematics for motoring's 'tomorrow's world' - disciplines Continental through its own efforts and previous purchase of Siemens VDO are industry leaders within.

[Although it has technical leadership in the R&D laboratory, it still needs to promote such innovation for industry and public acceptance, hence with its recent positive - we think overtly flattering - 'Consumer Acceptance of Electric Vehicle's' survey].

However, from Schaeffler's family owned, cash rich, perspective the timing of its interest in the far larger peer is near perfect. Frozen liquidity conditions in the credit-crunch fall-out have contracted, indeed battered, the stock-market. The upside for acquisition hungry hunters that many bourses are showcasing well below par prices for a host of sectors and companies, perhaps none more so undervalued as the listed, auto-related enterprises. Unsurprisingly the best deals to be seen are where the value-gap is greatest – and that means companies of major size with with high-value products and capabilities. As such Geissinger well knows Continental represents an attractive, value for money, prospect. Its divisions spanning a myriad of high-end, valuable technologies in:

a) Chassis & Safety
b) Powertrain
c) Interiors

And, per the norm, we have witnessed the usual negotiational 'courting dance' over the last few months as Schaeffler endeavours to courteously, yet forcefully, chase Continental taking increasing percentage of swap stakes via Merrill Lynch, openly highlighting its desire to take 30% of Conti but not be legally pressed into having to take and finance a latterday 50% controlling action – that German law presently demands. (NB Geissinger is hoping to ride the present day consensus for commercial legal reform and have the restrictive 'ownership onus' diluted to gain a powerful position within Conti but not be obliged to take on the weight of its legal requirements). This has all played out as his hostile initial bid of 70.12 Euros per Conti share has been improved to 75 Euros per share, and a thawing climate between the parties demonstrated by Conti's statement that “we will continue talks with the goal of reaching a solution to the benefit of the company as soon as possible”...”even as we evaluate other possibilities”. As to what degree Conti is really 'open' is debatable as reports indicate that it has been seeking 'White Knight' saviors from the Large Cap PE arena that could ensure a continuance of stability.

However, market conditions aren't great for PE and those large funds that have liquidity are spending much of their time reviewing the potential of investing in the diverse classes of asset and non-asset backed mortgage instruments banks recently had to put back on their balance sheets but are keen to offload at a discount (yet still ironically underwrite) to PE.
So the market understandably sees Continental as probably having to fight its own corner, and much of that will come down to the demands of its own institutional and large-holding investors. At the time of writing the share price just nudged over 74 Euros, not far off the 75 Euros offered. That we feel is the result of Conti's management 'persuading' (by whichever legal means possible) the price up to force Schaeffler in turn to re-offer at a higher level. Continental's management knows its value is well under-represented and is essentially pushing for time to 'run-up & run-out' Geissinger's bid.

At the opposite end of the spectrum, those customers which buy from both Schaeffler and Conti would rather see a friendly, magnanimous outcome rather than one which causes little operational disruption. And ideally see smooth possible absorption into an enlarged cost-saving entity which could pass-on a portion of those savings to customers. Theoretically possible, but pragmatically harder to obtain, especially if the Schaeffler family wish to see immediate returns on their M&A investment.

But whilst the individual players undertake their 'pitch and swing' bid tactics, there may be external government and industry observers who'll want to push to maintain a kind of unified front to German Auto. They recognise (as do the Schaeffler family) that Schaeffler's current position is untenable in the long-term and that has major ramifications for the economic livelihood of Herzogenaurach, its home town in Bavaria.

So ultimately, this episode in German industrial power-broking could be effected by the subtle influence of regional and national politics in seeking a fair result for all. One that avoids leaving Schaeffler in its long-term untenable position, and one that allows Conti to make use of the smaller companies good standing in precision, high quality mass components.

Exactly how the other primary stakeholders will react if this episode becomes a dilution of what should be an increasingly deregulated free, open market system is obvious, with much reaction resultant from their own expected growth forecasts. The likes of Capital Group (with its 2 Funds) ,Axa Group, Barclays Global Investors, Marsisco Capital, Societe General, Morgan Stanley-Wilmington and UBS will rightly have high expectations of Continental's longer term performance given the global growth of vehicle production and of course well recognise the traditional cycle of the auto-sector and the trough-point it now resides within.

So Schaeffler will have to pull something quite compelling out of the bag, or use its political might to help push through its bid. German industry has historically always been about a politically meshed group of powerful families, and as we see Porsche AG's inceasing hold over VW (both firms with major Porsche and Piech family interests) and the ever present Quandts at BMW, maybe Maria-Elisabeth Schaeffler & Georg Schaeffler and their sizable network will be plying invisible political moves to accompany her recent public PR appearances. This would accompany her 'Bavarian Order of Merit' as presented by Governor Stoiber and ex-German President Herzog.

This is indeed a testing time for Deutschland Auto GmbH, and appreciating the direction and nuances will be key for Continental's core investors as they in turn seek to see their preferred outcomes.

But too much political intervention raising the spectre of dilution to short or long term value-creation will not be welcomed.

Friday, 8 August 2008

Micro-Level Trends – Leasing Writedown Charges – 3 Plays in Hard Times

As industry analysts, execs and observers well know, automakers have had long love affairs with auto-financing, For the industry's largest players on what have been for far too long 'sliver margins' from their core activity of vehicle production, auto-financing has provided improved margins that some have factored into their operational NPV & IRR calculations.

Hence over the last 20 years VM's have build-up large internal or closely allied finance houses that enable them to both improve the bottom line through deal value efficiencies and enable easier signing-up of buyers. But whilst most have understandably entered the domain, the last year has seen individual automakers adopt differing strategic attitudes to managing a consequence of the credit-crunch – namely the downward spiral of used car values and the 'gap-effect' between theoretical book-valuations and real-world market prices. Given the relative rapidity of the 'residuals fall-out' each automaker is having to best guide its own financial fortunes, and that means best managing the need for sizable provisions set against book-to-market paper losses.

Ironically given the never-ending tides of woeful news from Detroit, the US 'Big 3' may be better placed in this market melt-down than its oft considered better placed European premium players. Two of the three previously part-sold or fully spun-out their interests in what were in-house finance arms. GM sold 51% of GMAC (inc Nuvell & ResCap) to an investment consortium led by the private equity house Cerberus in November 2006. Cerberus also took Chrysler Finance off the accounts of the newly created Chrysler Motor LLC, effectively separating car production and auto-financing interests), which was the fundamental basis to allow Robert Nardelli to announce Chrysler's effective resignation from the auto-leasing business. We assume that he critically does not wish to expose the semi-fragile automaker to the vagaries of Chrysler Financial and critically allow it to maintain credit-worthiness buoyancy for ongoing re-financing of its own. (Chrysler Financial was last week able to secure only $25bn of a desired $30bn credit facility) And as for the 3rd of the trio, Ford, its Ford Motor Credit division (inc PRIMUS & unlike GMAC concerned only with auto-related loans) has staid within the FMC domain and accounts-base.

Unsurprisingly trucks and SUVs have been heavily hit by the devaluation trend and the undermining of the leasing business model, perhaps most notable with Chrysler's high profile in this arena has been a factor in Nardelli's decision, but the greatest proponent of the lease system has undoubtedly been the premium sector automakers that so critically relied upon the rising economic tide of the last 7 years or so to sell to small and medium sized business owners, select corporate fleet and of course the credit reliant aspirant private buyer. Hence we've seen BMW vocalise their earnings hit and provision building to a value of -$1.1bn whilst Audi and Daimler are yet to declare any paper losses as of yet. They appear to be endeavouring to contain the situation, at least for now, perhaps preferring to take their heavy hits later as similar European market problems emerge or smooth-out the provision requirement over a greater timescale to lessen the obvious quarterly, half-year and full year earnings. There is even the possibly that it will try and perceptively negate the lost investor confidence of write-downs by balancing the books with new capital inflows. As it stands it seems BMW are being more transparent than its German peers, possibly because with greater volumes the condition is comparatively harder to handle and mask.

Although given their size Detroit's 3 operate far higher lease and loan agreement volumes than the European upscale peers, their deal-mix of internally financed deals vs external financing is comparatively lower, so from that perspective it lessens the comparative impact upon their need to set aside provision. Since more of their cars go out onto the open market, as opposed to being held by factory-owned or associated dealers the effect of the major car valuations slide should be paradoxically less than the closely held and managed premium Germans, and of course Lexus. - Infiniti and Acura less so.

However, as with any situation there are multiple perspectives, and a fortunate one for the Germans, if less so for the Japanese, is that the weak Dollar vs strong Euro FX rate means that the provision building which will be billed in Euros is less painful than if the two currencies were trading at a greater historic equilibrium level. Of course that plus will be of little consolation given the level of 'dealer corralled' used exposure the German's and Lexus actually have.
Recent WSJ, FT and other reports have highlighted the German corporations aim to reduce US volume so as to align to new car market demand and to undoubtedly help prop-up the pricing of used cars and so lessen the potential amounts of damaging future write-downs.

And of course, even Toyota has been affected by the slow-down in consumer demand, whilst a beneficiary of many consumer's flight from risk, their Toyota and high-margin Lexus models have taken a battering in a weary US, resulting in a 28% slump in fiscal 1st quarter profits. Even so the earnings were better than expected mainly thanks to the extra-ordinary accounting item gained from interest-rate swap contract. However, even so we suspect the charge against used car values smallest of the industry; a consequence we feel of that run to safety by buyers. The company's intended production cuts will we feel provide buoyancy to their US used car sales as buyers fear/avoid buying new and instead look for quality near-new products. That in turn will help Toyota stay ahead of the pack as economic gloom continues to bite and possibly worsens.

As we view the situation today, the accompanying graphic (top right of this page) represents only a momentary, quickly compiled 'snap-shot' of expectation of individual automakers' write-down & provision-building approaches and tactics. Each according to one of 3 'shareholder expectation plays'

It is laid out as a 3x3 table illustrating the timing of each VM's write-down absorption vs the level of comparative 'hit'. The timing is labeled as “Early Absorption” (Q208-Q209), “Deferred Absorption” (Q408-Q409) and “Ideally Avoided Absorption”. Thus this overview tries to read between the lines of VM actions, and the way it is managing its US used car pool so as to best manage investor relations, whether that be with open early-days transparency to manage expectations (for perhaps an early latter day earnings come-back) or by deferring the hit and riding the present-day's 'on or above par' share price, or possibly trying to massage and manage its way out of the problem.

[NB These are only initial perceptions, not a fully analysed prognosis]

Wednesday, 6 August 2008

Industry Structure – Input Costs – Steel Derivatives:Forging Changes in Steel Procurement.

Whilst CEOs and CFO's concern themselves with what has been an historically startling recent story of cost-push inflation, the financial & commodity markets have sought to exploit this period of instability so as to both hopefully gain from corporate executives discomfort and theorectically allow corporations to smooth and better manage their own input prices.

The emergence of 3 exchanges dedicated to the Forward Contracts of finished steel variants demonstrates how the once mundane, low value, metallurgical product has escalated in demand over the last decade as Asia's manufacturing and infrastructure economic and societal expansion acted as a powerful catalyst in driving up steel demand and so prices as supplies, and the mining to finishing value-chain, came under severe pressure.

Steel occupies the 2nd largest commodity market, junior only to (unsurprisingly) oil, with a global value of approximately $500bn. And it comes in 3 main forms:

1. Base Billet (bar form) – used for rods, rails, pylons etc
2. Semi-Finished Billet (bar form) – used for re-enforced and engineered solutions
3. Hot / Cold Rolled Coil (sheet form) – used for automotive bodies and consumer goods.

Given the relatively stable, long continued growth in steel demand , we are surprised at the time taken by traders to develop steel orientated exchanges, but suspect that there must have been much discussion regards which bourses create exchanges for different steel product / finish types to avoid their own in-fighting and trading margin erosions. It had long been thought that each bourse could offer services for each steel product type, but the markets hadn't developed as expected as constant inflationary push, and so rising prices, meant that steelmakers would rather provide at timely and market-sensitive spot-prices rather than at secured longer-term, often lower margin, contract prices.

The opposition is still presently understandably prevalent from leading steelmakers such as ArcelorMittal as Indian, Chinese, Brazilian and other nationalised and private large corporations make record profits and face new consolidation challenges to maintain their own momentum. But, the medium and small sized firms reportedly welcome the initiative as 'opening up their potential'. However, perhaps as the Asian economic slow-down appears over the horizon (intimated by the well placed HSBC) those same leading producers that have 'made hay whilst the sun shone' may start to see the advantages of a well constructed, transparent market that finds supply-demand equilibrium, and so allows for better operational and CapEx planning in what looks to be a slowing and perhaps even contracting steel environment. This is of course very much in constrast to the often opaque pricing that has been an element of the seller's market recent years, but a sharp slow-down and new sluggishness in BRIC regions would bolster the pronciples of such bourses.

Earliest on the scene just under 10 months ago, on the back of its own massive infrastructure development programme was Dubai, its DGCX exchange focused on the contract trading of Semi-Finished Billet that goes into many of its new skyscrapers; as much a national endeavour to best-price steel procurement in rocketing times as that of earning exchange commissions. Next to arrive was the London Metals Exchange (LME) focused on Base Billet and operating in a context of broader applications, but very well positioned to gain from what is primed to be massive infrastructure investment policies throughout Europe and US.

But the major news for the long suffering auto-industry is the arrival in Q408 of the New York Mercantile Exchange's (NYMEX) version, focused on Hot-Rolled Sheet Steel that is the staple of the US auto industry. (Previous studies indicated that this raw material cost accounts for approximately 15% of a medium sized vehicle's production cost). The NYMEX bourse, unlike DGCX or LME with an options base, is dedicated to financially settled contracts, giving automaker buyers far more confidence in their mid-term production budget projections, which in turn allow greater stabilisation of cashflow and strategic options picture building.

Having endured such heavy input cost headwinds US executives will be keen to leverage such newly available assistance to steady their rocky rides. Indeed for all of Detroit's Big 3 and the likes of Toyota, Hyundai, BMW, Mercedes etc with US plants, the news of the NYMEX venture will be welcome indeed.

The very fact that the Hot-Roll Sheet market will be based in the US makes a fundamental difference to global seller and buyer perceptions, giving the US a much needed economic and industrial structural boost since now instead of looking directly to Indian, Russian, Chinese etc sellers, VM's and the Supply Chain will increasingly look to primarily the NYMEX but also LME and DGCX as intermediary market modulators.

The obvious struggle will be between automakers and the steel-producers, relationships will have to be sensitively managed as automakers seek to exploit the willingness of smaller steel producers and the exchanges against the entrenched positions of sector leaders. investment-auto-makers believes that we could possibly witness a fracturing of the steel industry as nationalistic BRIC-based producers are put under pressure by their own governments to focus on domestic price sensitivity to keep their individual economies moving forward as fast as possible in a globally restrictive climate.

That in turn will pressurize said BRIC producers to ramp-up capacity to maintain margin and either sell directly (as today) but on non-spot price agreements or 'go to market' endeavouring to make up the revenue differential. And as an inflow of FDI goes into the states over the next few years o n the back of a devalued Dollar and underpriced industrial asset-base, so the FX $ value will climb against the normative international basket of currencies and so 'market-sold' steel capacity (in $) will assist the balance sheets of those BRIC steel-producers.

In the mid to long-term, automakers should start to see the headwinds deteriorate with slowed inflation and more trading transparent, whilst steel-makers may in turn be put under pressure and seek alternative pricing models via the NYMEX and beyond; perhaps even creating a bourse of their own to claw-back their own power in the decades to come - just as investment banks have sought their own exchange facilities (eg Turqious et al)

But for the moment the signs are that finally the auto-industry, US in particular, could be seeing the much needed change brought about by not regulatory reform, but by Adam Smith's principles of created markets relative to macro and micro pressures.

Monday, 4 August 2008

Company Focus – BMW AG – Corporate Re-Engineering to Better Turn the Corner

The initials 'BMW' are renowned as representing the sine qua non of automotive achievement, in both respects as the creators of the archetype aspirant volume car and, as a consequence and more importantly for investors, the archetype ROCE & ROE value driven automotive company. From Wall Street's perspective it provided the returns that seem to mix the best of Porsche and Toyota.

It was a company whose very organisational DNA derived from the same ethos as that which engineered the cars – relatively lean and lightweight (in structure and reporting), a controlled centre of inertia (at board level), balanced masses (between R&D and productionisation), low unsprung weight (enabling quick action) and above all the ability to transmit, feel and read the external environment (reacting to its stimuli). In short a corporation, like its products, that was able to act beyond the sum of its parts. It was an environment developed by the likes of Piechestreider and Reitzle, a culture that merged old school Munich pragmatism with broadscope NYSE acumen to develop a focused product development capability set within a worldly, future-forward business strategy. This ideal was nurtured as the company grew on the back of the last 20 years worth of economic expansion in traditional markets, which boosted by ever expanding global liquidity and credit, allowed many an aspirant consumer to fulfill their BMW dreams.

But the halcyon days of BMW's auto-sector leadership have faded as the fall-out of the global credit-crunch takes effect and the middle-ground consumers, that could buy into the dream via credit and affordable product lines, seriously re-consider premium purchases. Of course, for a company like BMW it will be a test of how management rides the choppy waters of a possible global economic slow-down, even tho that slow-down still promises great Asian potential and the mid-long term prospect of a re-vitalised West post 2010...[note how commentators are pushing out the forecast for western 'bounce-back].

So whilst Piechestreider and Reitzle were able to enjoy their rapid expansionary and extremely profitable times at BMW, today's picture for Reithoffer looks very different. With slower revenue growth rates (expected given greatly increased volume) and far greater external macro headwinds. But the H108 results appears a bitter pill to swallow when global deliveries are up +4.7% at 764,874 units and group revenues are up +4.5% at 27.837bn Euros but group EBIT profitability is down -35.2% at 1.243bn Euros; of which only approximately two-thirds is automobile sales contribution.

The key indices chosen by BMW last year to demonstrate highline performance are EBIT-Margin [ie EBIT/Revenues] and ROS [ie Profit Before Tax / Revenues], measures seen as being analytically friendly and easily digestible for investor comparisons.

On these basis, the H108 vs H107 EBIT-Margin figures demonstrate a significant drop for the Group (at 4.5% vs 7.3%) due to a fall in the Autos division (at 3.9% vs 5.8%) and the Finance division (at 1.5% vs 5.6%). Whilst the Motorcycles division performance has stayed flat (at 12.5%). Similarly, the H108 vs H107 ROS figures tell a painful tale, Group down (at 4.5% vs 7.2%), Autos down (at 3.3% vs 5.5%), Finance down (at 1.9% vs 5.7%) and Motorcycles flat (at 11.8%).

The Finance division is perhaps the greatest concern given that BMW has historically been perhaps the greatest advocate of internal sales financing and thus benefactor; the credit crunch's effects are plain to see. Although the number of lease and finance contracts rose 12.9% vs H107, it must be recognised that the company has very probably been forced to tale-on lesser quality applicant credentials, given that other lenders have seriously retracted deals and that BMW will have had to partially fill the contract market's recent vacuum.

Unsurprisingly the company has adjusted its (we think) previously over-confident outlook, so as to portray a more realistic harsh consumer environment. [NB Many automakers were optimistic in forecasting an '09 upturn, now post-poned to 2010].

This re-assessed outlook will necessitate further internal re-alignment measures, that go beyond last years unpopular 4,000 post retrenchment, management stating that it seeks a staff cost overhead expense reduction of 107m Euros. This will partly assist the much needed provision (stated at a value of 695million Euros) required to offset the substantial devaluation of USA re-sale vehicle residuals. The US market has pounded BMW not only relative to the weak $ rate for imported vehicles, but also obviously hit hardest regards used car demand, premium used cars always suffer badly with economic declines. In reaction BMW is rightly decreasing volumes in a bid to maintain used and new car values.

All this makes for testing times indeed, as Reithoffer's press announcement stated “We will use the strong headwinds as an opportunity for change and continue the process of renovating and optimising our business in conjunction with strategy Number ONE. We must and we will intensify our efforts on both the cost and revenues side even further”.

Of course, in the face of such strong input cost and mature market stagnation headwinds organisational efficiency and improved productivity will be key, but the investment community will want to see detail behind the broad statements and obvious data such as data tables that highlight the sales success of !-series and Mini 2 in this cost-conscious environment. [A pertinent point to state that Mini ONE sales volumes need improving in its own right with targeted initiatives, done so intelligently without cannibalising the other higher margin variants]. Unsurprisingly the big car sales are down, with the exception of newly introduced X5. (Newish) 3-series is down 11% which given that it historically acts as the revenue standard bearer, but plainly the most demand elastic, is a substantial margin hurdle to overcome, even with the 'Efficient Dynamics' technology card played. Our real concern is new X6, and its abilities to meet mid-term western market volume targets, hear and now it appears more than just a little out of place, dare we say even folly-esque.

Small Cars will bear much of the responsibility and it is here that BMW really must demonstrate its commitment to the consumer and the capital markets. Whilst 1 series is improving in terms of market acceptance (esp Asia) and Mini has broadened its range with Clubman, greater exploration is needed to examine what other variants and spin-off models can be created. This will be the remit of the BMW-Alfa Romeo joint project team codenamed 'Butterfly' seeking conjoined engineering and production and possibly marketing synergies between the German and Italian corporations; saving approximately 250m Euros each. [investment-auto-motives believes the savings could be higher than the 150-200m Euro stated by analysts in Automotive News Europe 21.07.08]. But results, and critically income, will not be seen until 2012, so interim initiatives must be assessed to expand the role and contribution of BMW small cars, though possibly near-term constrained by UK and German capacity.

And beyond, as investment-auto-motives recommended over a year ago, BMW must examine the potential for its own equivalent of the 'Kei' category, yet smaller light-mass 'Quad' vehicles primarily dedicated to city use, spiritual successors to the 1960s Isetta in philosophy if not in style and function. BMW must merge its auto & motorcycle expertise to create a 'new order' for attractive light cars that follow in the footsteps of Daimler's >smart . We understand experiments / developments have since been underway (prompted by ourselves) but BMW R&D are being typically kept in the shadows. Once again BMW should seek another VM JV partner to develop the idea, ideally Daimler or Audi to promote prestige high-tech German origins and retain premium differentiation in the marketplace. Or indeed utilise the Mini brand to create a 2 tier, broader span, family.

Regards BMW's intrinsic sporting character, the new 2010 Z2 will do much to re-invigourate the compact sports segment, and theoretically should arrive when we see economic confidence return, so well timed for lower-cost, self-gratification personal motoring.

But in the meantime, on the input costs side of the commercial equation, BMW – like its VM peers – will need to negotiate hard with steel suppliers who are currently leveraging the incredible global demand by predominantly insisting on automakers paying 'spot-priced' steel – a result of their own inflationary input cost (iron ore and coking coal) experience. BMW needs to convince steelmakers that the recent economic explosion is set for slow-down with meaningful evidence, so as to negotiation sales back to longer-term contract-based agreements, providing improved revenue stability for the steelmakers, assisting them in their own CapEx planning.

As it stands here at mid Q308, BMW finds itself in a precarious position, with both heavier 'drags' than many of its peers (esp the European small car Vms) but also greater organisational and brand 'potentialities' that would assist a turnaround. The company must return to its philosophical roots and previous corporate 'go-getting' mentality. It must attune product and commercial acumen to plot its way forward – using the present headwinds to its own advantage. Joint Ventures will promote major cost savings but BMW cannot afford to dilute its unique and definitive offerings during what will be a very pressured period. But it is in such times that “who dares wins” and BMW is perhaps best placed, with its commercial momentum and R&D efforts such as GINA, to retain the crown as an originator.

And this is our concern. Reithoffer will be caught between the innate conservativeness of an understandably introverted, risk-averse financial management team and more extrovert product team. His and other Board member's remit is to balance the strategic friction, so as to keep the company on an upward glide path regards its cars and motorcycles, yet doing so with great great pragmatism.

The investment community demands greater transparency from Munich to see and understand how it will reach the rapid ascent from 2008's 4%, 2009's 6% & 2010's 8-10% EBIT-Margins. It will want to see more signs of BMW's confidence in itself and its future as the iconoclastic automaker.