Wednesday, 24 September 2008

Industry Structure – Clean Energy Solutions - Taxi-ing for Take-Off ?

The adoption of clean energy solutions by the auto-industry, and critically the car-buying public, has long been a problematic, as intertwined practical, financial and psychological factors play primary roles inhibiting adoption.

Of course the Kyoto Protocol 'awakened' different nations at different rates, those with greatest technology advancement, regulatory power and social-engineering able to re-orientate resources to meet the climate challenge early – Japan being the best example with 'coercion' if not direct assistance in Toyota's and Honda's mass-productionisation of Prius and now Insight 2.

The almost omnipotent Chinese have 2 of those 3 macro-enablers at their authorities fingertips, whilst the 3rd, advanced technology, is only a short distance away in the form of their historically remote, but now commercially close, neighbour – Japan. Itself seeking product, service and IPR export to spur its own low growth economy. And remember the Chinese are familiar with modes of 'Clean Energy Transport' with electric bicycles and mopeds being the fundamentals of personal mobility for millions. Hence embracing a truly practical and convenient electric car is a far less daunting for first time buyers than for the Western populous. This is the theory at least, though of course the UAZ Jeep to the VW Santana could have been said to lay the populist perception of the 'adopted' Chinese car. But it could be argued that the Communist Party of China seeks to create a true national Chinese Car derived from the 'progressive' engineering concepts / demonstrators spot-lighted the Beijing Auto Show?

The West has obviously had greater commercial, financial and societal headwinds in terms of such a radical re-orientation of its personal and public mobility construct. Relative to the Car per se, there are enormous, and understandable, barriers to change; ranging across the:

1. Psychological (110 years of using the internal combustion engine and its attuned worldwide supporting infrastructure)
2. Attitudinal (where cars are effectively 'status ranked' according to ICE cubic capacity and conventional ICE engineering capability – see BMW and Mercedes)
3. Economic (the fact that the massive auto-industry – upstream to downstream- is orientated around ICE business model)
4. etc etc

However, as of literally today a confluence of issues and trends may be about to give alternative propulsion re-newed traction here in the United Kingdom, it's epi-centre: The City. The City, for all its current woes is political & geographic merged field reflecting 2 timely and important events, which if logically combined point to the the beginnings of what could be a major wave supporting electric vehicles.

Firstly, The City has been the facilitator of the just announced £12.4bn deal that saw France's EDF Energy buy control of British Energy (with expectations to sell-off a 25% stake to Centrica). That essentially proffers the nuclear-able skill set to both re-condition the UK's current 30 year old reactors and build a rumoured 4 new nuclear plants to provide the UK with much increased electricity capacity over the coming decades. Capacity that could charge electric vehicles.

Secondly, The City is the geographic and spiritual home of the London Black Cab, a vehicle which has always had a special genealogy and DNA set by the strict standards of the Public Carriage Office, itself obviously under UK government control. Such standards, in the interests of public policy, have historically made Black Cabs genetically different to mainstream cars, whether in terms of passenger capacity, maneuverability, standard of service etc etc. But today the PCO is under government pressure to transform the emissions output of the iconic taxi, which even lags mainstream people-carriers due to aged powertrains. Given London's leading role in transport policy (ie Congestion Charge & emissions reduction) there is a strong case to state that there is a governmental desire to see the Black Cab leapfrog forward to achieve the world-wide gold standard. That means that the vehicle and its design may have to undertake radical propulsion transformation, employing Plug-In Hybrid & All-Electric technology to ultimately conform with ever constricting policy guidelines which may well be being drafted.

investment-auto-motives appreciates the 'serendipity' of the present-day unfurling events.
The occurrence of engine fires on 8 TX4 vehicles (registered in mid 2005) in the space of 3 weeks required the PCO's withdrawal of an initial 10 Black Cabs from the road for inspection. A failure to determine the fire's cause lead to the temporary retraction of 500 driver licences for those operating other '56-plate' (mid-2006) vehicles to avoid the possibility of endangering the public. And now a further 70 later registered 2007 vehicles, sharing similar chassis numbers (and so specifications) have been suspended.

The PCO could well argue the point (and objectively conclude) that these unfortunate, non-isolated 8 similar accidents highlights a critical design flaw within the TX taxi range's aged powertrain set.

That in turn would call for a complete re-design of the TX's propulsion unit, which as part of a changed standards policy, would undoubtedly demand radical new emissions standards to be met, very probably matching or beating the European Commissions 120g/km target for (originally) 2012 – now being lobbied by automakers for postponement until 2015.
Thus the watershed agreement between EDF and Centrica that crystallizes the UK's energy policy to invest heavily in a new generation of nuclear powerplants, would logically and deductively, be aligned to a new impetus to invest in PI Hybrid and All-Electric powerplant technology for London's iconic taxis. An impetus that is being built-up in the presently on-going UK Automotive Inquiry which seeks to re-vitalise UK industry as a front-runner in green propulsion technology.

Manganese Bronze is the holding company of LTI Vehicles (formerly London Taxis International), the maker of the TX cabs and owner of Mann & Overton and KPM, arguably the duopolistic retailers of the vehicle in London. Importantly, MB also already has strategic interest in the electric propulsion arena. It has already created a network of technology alliances with the likes of Tanfield (owner of Smiths Electric Vehicles) to produce an EV taxi and for Hybrid technology utilises the knowledge of Azure Dynamics.

Thus MB is strategically “ahead of the curve” when it comes to regulatory demand set out for the PCO by Transport for London, a division of the Mayor's office. Interestingly TfL also introduced a second tier fleet of black taxi's based on Ford and other MPV type cars, created it was argued to “soak up additional un-met taxi-ride demand”. Fortuitously, this fleet can also soak-up the loss of the 600 or so TX's taken off the road in the interim.

investment-auto-motives believes we are witnessing the beginnings of a radical transformation of the Black Cab and the possible underpinnings to achieve the UK Inquiry's ambitions to transform the UK auto-sector .

That transformation, using the Black Cab fleet as a springboard, positively encourages production economies of scale that can be pragmatically commercially absorbed and amortised. Given the high-cost of such a niche vehicle, typically £35,000, a notional technology induced on-cost can obviously off-set as an item of depreciation on a cabbie or fleet operator's commercial accounts. That important ability could act as a half-way post to further 'volumising' electric vehicle propulsion sets for more mainstream fleet and ultimately private vehicle applications.

Strategically for MB, having set up a components sourcing and assembly partnership with Geely Automotive and a distribution office in the USA, hopes to both dramatically reduce assembly costs, so as to also absorb electric propulsion drivetrain costs in its ex-factory vehicle costs, and extend its global reach to both Beijing and New York; as each of those cities expect to introduce follow-on London-aligned taxi transport policies.

Thus with the EDF deal and Black Cab incidents, we suspect we are witnessing are confluence of events that will ultimately help mesh the needs and visions of UK Auto plc, itself and its accompanying players acting as a vanguard of public-private transport policy progress on the global stage.

Tuesday, 23 September 2008

Company Focus – General Motors – Avoided 'Shorts' and Looking 'Long'

The stock market is, as ever, a milieu of mixed opinion. It's that very fact that creates capital markets, a fact that over the last 11 days or so been the illustrated beyond doubt through the dominance of 'shorting', a much debated tri-part, tri-opinion trading strategy that speculatively injected the latterday major turmoil that further undermined the US financial sector.

The Fed and SEC stepped-in after the collapse of Lehman Bros and effective collapse of AIG to try and halt the blood-bath, effectively telling Capitol Hill of its actions after the event instead of seeking prior approval, as would be the norm.

A major aspect was of course the temporary and indeterminate prohibition of 'Shorting', the consequence of which wiped billions off of investment banks' capital values, and a threatened to continue as a trend amongst other theoretically less vulnerable sectors...such as industrials and autos.

As a safe measure, and recognising the acute contagion that could result, the regulatory authorities took a step-back to draft a list of those large companies that it considered essentially 'at threat' . General Motors, though of a relatively low market capital value compared to other 'high-value' corporations industries, is through its own propping-up of Delphi and other up and down-stream interlinks obviously still critical to the national economy and as such had to be protected.

But of course where the capital markets cannot short, investor sentiment will be evident enough in the rise of company stock sales, and GM's recent 11% plunge only adds to the pain of a 53% 12 month slide and noted as the worst performer in the Dow Jones Industrial Average Index.
Detroit is of course in the process of endeavouring to secure the initial $25bn low-interest loan from Congress and ironically as GM's price slides and it's rate of valuable cash burn increases (drawing on the final tranche of its final $3.5bn revolving credit line) so the need becomes more evident and incontestable from Congresses.

Though we agree with a Citi note that this doesn't yet demonstrate financial distress, GM having approximately $19bn cash at hand at end Q208. Yet equally it can't be denied that in these presently frozen financing conditions accompanied by declining global vehicle markets, that the corporate cupboard is being quickly depleted, even if not bare.

Most recognise that it will be the availability of corporate liquidity that will act as core- sustainance in the journey ahead, for however long that takes - a lesson was well learned by Japanese companies over the last low-growth 15 years. Not that the US is expected to experience such pain, simply that at such cash-critical times the need for an imminent $8bn to assist hefty operating costs is far more preferably achieved via Congress. This is undeniably a far more ameniable source compared to high cost bond issuance since Fitch re-rated GM onto “CCC” (6 grade into 'junk'/'high yield) or indeed running the risk of failing to ensure the underwriting and full market acceptance of additional equity issuance.

[NB. that rumoured/appropriated $8bn being unsurprisingly approximately one-third of the $25bn (initial) sum sought by Detroit's Big 3].

As things stand, the markets appear to be awaiting that critical Federal assistance and in the meantime rationally drawing down the price to both:
a) gain on the upswing of a very probable Fed announcement, and conversely
b) appropriation natural decline to have the stock find a natural p/e bottom to reflect what would be disappointing earnings outlook.

The biggest investor concerns are of course net income levels and the rate of 'cash burn'. Although Q307 & Q407 had hefty and record $37bn losses, the vast majority of that was due to deferred taxation and elected use of working capital, thus were seen to a degree as extra-ordinary factors unreflective of ordinary operating profit . However, although far smaller the Q108 and Q208 losses of $3.25bn and rapidly formed $18.7bn appear to be pure operating losses with Net Cash declining, Q107 at -$1.59bn and Q207 at -$2.2bn; down heavily from what were (in comparison) buoyant late 07 figures. Analysts and investors know that losses have been incurred on the back of an ever sickly North American home market, they are keen to see that the company retains enough cash to ensure it gets through this biting (now recognised) recession....and onward to 2011 to enable exploitation of an eventual US consumer upturn mid/end 2011.

However, over recent weeks the 'cash burn' question has grown more prescient given the the fact that the 'fiscally assistive' overseas EM markets (BRIC particularly) are now contracting rapidly. Although still in comparative growth mode, the level and speed of economic slow-down is concerning. Once confident Chinese, Russian & Indian consumers have, due to cultural impetus and lack of credit reliance, reacted quickly to the financial turmoil eroding domestic stock markets and so subsequent economic outlook. Only Brazil stands at best static, better than nothing, but of little effectual consequence relative to a large global corporation such as GM. Although market leaders in China and Russia their size and exposure to highly elastic, promiscuous and now cost conscious buyers will be problematic.

As margins in China have been squeezed over the last year due to the intensity of competition, so we'll see the same effect in Russia, though note not to the same degree. Just how it plays out it terms of model mix market demand and VM's reaction we'll have to see. But whereas slowdowns invariably boost small car sales – as seen in US and W.Europe – consumer's status-orientation is a dimension of emergent car markets that shouldn't be under-estimated, so careful regional planning will be required to balance production and costly import volumes of local portfolios.

Thus at this juncture, GM (like its Detroit brethren) faces yet another headwind. Unlike the former mid-stream UAW & legacy costs, or the upstream problems of price-spike oil and accordant massive input-price inflation, the focal concern at present is demand and profitable output. The adjustment of region EM demand will undoubtedly be required, and may halt EM projects to conserve cash, but equally important will be the need for GM to replicate its negotiational skills abroad (as seen with UAW, Delphi & now Congress relationships) to broker new business bases that suit the potentially dramatically changed commercial environments within the critical 4 EM regions. Even if BRIC growth is simply a 'hiccup' as some suggest, all the better to use this period to ensure improved margins at the earlier up-turn.

Speedy, large scale cost-savings across the board is what analysts will want to see to 'right-size' each regional division to suit the near and mid term, ie 2009-2011, so as to see GM pick-up across the globe post-2011.

But the biggest question remains, that today at the the company's centennial year, what shape should a 21st century GM take - structurally, operationally and fiscally?

Given the intrinsicly low profitability delivered by a traditional capital intensive mid-20th century business model, now better suited to Asian economies as seen by the Auto's C of G shift, in which direction should GM be moving? Importantly what is the routemap for getting there?

Yes there is the showcasing of the plug-in 'Volt' and the promise of a new world automotive dawn to combat energy price and security issues, but that will take many years to become the norm given technical, manufacturing and infrastructure headwinds. Thus even if the mechanical engineering that supports GM stays largely conventional (bounded at mild and mid hybrids), why should its operational/organisational structure remain the same?

Yes electric vehicles promise improved profitability when the technology with an inherent reduced BoM is enabled for mass manufacture, and efforts must be kept going But why stop there? Couldn't the nervana of profitability be extended further still by re-engineering the company as a whole, step by step by step? Effectively adding a commercial business model 'range-extender' of its own.

For even heavily regulated capital markets will want to see new realms of value extraction and those actions need not stop at the product, or indeed traditional operational activity. In a much changed world of consumer-corporate symbiosis, value extraction through philosophical transformation will be key, it should be part of a corporations own profit maximisation agenda and be intrinsically woven into CSR ideals.

For the moment, the future seems a long way off, nonetheless, GM investors – especially the 'large-slice' funds – will want to see how the pragmatic reactions to today's demands are aligned within the scope of long-term ambition.

Investors and Congress will not want to GM simply take another skip around the same old mulberry bush with private and tax-payer's money. Both deserve to see and recoup from far more.

Tuesday, 16 September 2008

Company Focus – Volvo Cars – the Revolving Wheel of Fortunes in Gothenburg

As Ford and its Detroit brethren court the senators and purse-string holders of Capitol Hill - seeking the initial $25bn tranche of an ideally $50bn+ deferred low cost Federal loan - so FMC must concurrently also scope the value and potential of its remaining asset base to determine its budget contingency and so mould appropriate forward strategy.

In an environment where GM has HUMMER up for sale, Chrysler seeks to divest of the Viper business and the former step by step dissolution of the once mighty Premier Automotive Group (PAG) has set an apparent precedent within Ford, no-one is surprised that in recent weeks there has been much conjecture surrounding the fate of Volvo Cars. And the rumour mill has fairly buzzed at the expected 'parachuting-in' of a seasoned Ford executive in the shape of Stephen Odell; replacing on 1st October the much respected, but presently poorly politically positioned, Fredrik Arp.

Volvo, although part of PAG, always retained far more independence than many other Ford holdings, its most noted peer Mazda. Whilst Volvo served by providing various new generation large & mid platforms for FMC en masse, the nub of the business was always Swede-centric so as to retain a sense of self when attempting to grow volume via its crop of large and mid X-overs and large, mid and compact cars.

Previous buoyant economic times allowed for that level of autonomy given that Gothenburg was philosophically integrated, even if not administratively, acting as Ford's centre of competence for AWD drivetrains, safety technology, telematics & ecological technologies. Critical elements which under PAG ideology were to create a low-cost technology trickle-down hardware & software streams into blue-oval's mainstream products to keep them as respective class-leaders.

However, it is that very synergy and level of inter-dependence that is now being questioned by Detroit, Gothenburg and of course the investment community. Once seen as the perfect 'half-way house' relationship under a different era, times and corporate structure have evolved since. As the world's economy looks to absorb perhaps the biggest financially induced shock yet with the collapse of Lehman Bros (and its resultant squeeze effects on margins, budgets and disposable consumer consumption) so American industrialists will be seeking risk-averse strategic courses in what are very very choppy waters.

As a consequence of the last year's increasing turmoil, rationalisation exercises have been underway at Volvo Cars for the last 2 quarters - ever since FMC quoted a Q108 loss of $151m and subsequent H108 loss of $271m (compared to a previous recent peak of $3m profits in H107). [Though of course FMC accounting and appropriation of expenditure vs income cannot be wholly ruled out as it itself seeks to convey better figures for core blue-oval operations]. Whether wholly market-induced or partially financially engineered, that rationalisation has taken the form of headcount reduction (1,400 white collar & 600 blue collar) and a general 5% output reduction subsequent to the previously announced Torslander site's activity reduction due for October.

But the sign of the times is senior management change. Where as Arp held great goodwill from Volvo's supplier-base, dealership-base and importantly governmental contacts, it was no doubt felt that such 'bon ami' was counter-productive to this new period which requires 'hard-ball' negotiating with all internal and external stake-holders. The fact that Odell is the first non-Swede to take the reins at Volvo (additionally supported by non-Swede Steven Armstrong as COO), we suspect, demonstrates the seriousness of the stance that FMC seeks to take; intentionally distancing itself. If it was simply a matter of Volvo 'tinkering', keeping the business as an 'arm length's division, the necessary ongoing restructuring and stakeholder conversations would have been better (politically) accomplished by Arp or another respected Swede. That appears not the case, Detroit wanted a direct line to Gothenburg and is using Odell to ensure that it is accomplished.

At the matter's heart, Odell will be weighing-up pro and counter arguments behind the strategic disposal of Volvo Cars versus complete absorption into FMC:
Basic, preliminary thoughts from investment-auto-motives regards the black and white scenario choices are as follows:

Scenario A - Divestment (“Opportunity Cost”) :
1. The need to tread a fine line between cherry-picking retained technologies, valuable transferable capabilities & facilities whilst maintaining a attractive entity that would muster potential buyers.
(This greatly influenced by FMC's future 'make vs buy' philosophy)
2. Assess the level of potentially 'fiscally encumbered' deflated asset values - land, buildings, plant etc. (Though this could be less than instinctively presumed given Sweden's fortunate apparently limited direct domestic banking exposure to the global credit crunch).
3. Evaluate the potentially loss of future competitive advantage in Safety, Telematics & Eco IPR
4. Identify 'best-fit' suitors (assisted by a NOMAD) between trade, MBO/LBO, PE and possibly governmental interests.
5. Negotiate contractual FMC support & non-compete clauses. (regions / time-frames etc)
6. Develop an alternative FMC strategy for 'from scratch' creation of new Eco-associative Brand

Scenario B - Volvo Retention (“Cost / Benefit”):
1. Press for Swedish government assistance (grant, subsidy, tax credit incentive etc)
2. Continued operational rationalisation merging Volvo into FMC , deleting double-count activities and severely contracting autonomy (ie 5 cylinder engine design and manufacture)
3. Negotiate extended supplier leverage & demand co-op project and plant / tooling investments.
4. Supplier initiatives to gain volume economies and reduce payment, logistics complexity
4. Cost-down on R&D and project engin'g to reduce the competitive gap against low cost regions.
5. Assess dealer-base ownership structure to improve 'ex factory - retail' margins & customer experience, CRM and create repeat buyer loyalty.
6. Critically evaluate Volvo's brand and product strategy with serious consideration of alternative secondary, separately positioned new look & feel or sub-brand.
7. Develop a robust FX hedging strategy for the near to mid term (1-3 years) for US$ volatility.
8. Seriously consider Volvo production in the US (on flexible Ford & Mercury lines) scaling up Volvo volume as the Mercury marque continues its inevitable decline; assisting unit margins.

Of course, these are only a few highline considerations amongst a myriad of issues for both scenarios. To fully assess the ramifications of each scenario and make a fully explored decision would take time, but time is a luxury that Odell very probably doesn't have.

FMC and Mulally have heard supportive sound-bites from the Tracinda PR machine, but equally it and other institutional investors want to see plausible solutions to the haemorrhaging of Ford's P&L and an evidently uncomfortable rate of cash-burn on the quarterly Balance Sheets. Thus the relaxed and amiable Mulally will be trying to manage shareholder expectations, retain goodwill and effectively buy time .

The investment community would unsurprisingly be particularly interested in the sale potential of Volvo, both as an investment vehicle in its own right, as the probable short-term upswing in FMC stock value as the market would perceive such an act as effectively “lifting a weight off the corporation's shoulders”. Indeed Odell's statements that “Volvo will be more standalone” positively courts such conjecture. So looking slightly deeper at Divestment, which parties might be interested in Volvo's acquisition? As ever, potential candidates derive from Trade, Private Equity or the latter-day sizable influence of Sovereign Wealth Funds (esp Arabic & Asian).

In regard to the general trade sales environment, given today's current and worsening contraction of credit availability in western markets - where corps are willing to buy expensive short term paper to cover short/mid-term operating – the bygone possibility of heavily leveraged strategic M&A has drastically demised.

There has been press speculation that Renault-Nissan might be a potential given the French company's interest at time of Volvo's sale to Ford, but given the Franco-Japanese's companies organically developed leaps forward in both safety and eco-tech in the interim, the worldwide marketing of upscale Infiniti competing directly against Volvo and Ghosn's own performance pressures to fulfill R-N shareholder expectation, an additional car company purchase is looking very remote when he (like many CEOs) seeks the benefits of alliance partnerships over the headache of financing and meshing a 3rd entity with little upturn.

PSA, now coming to the fore playing its strong small car range and CO2 credentials, could theoretically be interested in gaining a premium brand to both reach into that territory and gain further volume economies on its larger platforms, but PSA has historically favoured alliances not M&As – its imbued in the Peugeot-Citroen DNA - and seen yet again recently with Mitsubishi partnering on larger vehicles and diesel & electric powertrain solutions, and major emerging markets potential such as Russia & Brazil. Integrating Volvo might be biting off more than it could chew, and the very pragmatic Streiff, renowned for seeking efficiencies, recognises that.

As for the German's, would either BMW or Daimler, both with their own performance issues, want to acquire a foreign company after the respective Rover Group and Chrysler 'divorces'? Probably not. Reithofer and Zetsche recognise that jittery capital markets will want to see them sort their own house-keeping first and will not speculate so rashly with valuable cash at hand or costly debt; if indeed available. Volkswagen has been running well as the doyen of the auto-stocks, but as of today it has the internal & external political concerns regards integration into Porsche Holdings. Whilst that should theoretically be a smooth process of conjoining 2 well associated, already cooperative firms (eg Toureg/Cayenne, Panamericana & smaller siblings) the reality with inter-family power-struggles and the case being pursued against Porsche by the State of Lower Saxony (seeing itself as 'defender' of VW) means that the situation is far to messy to seriously consider a acquisition and integration.

This leaves FIAT as the last major European candidate, again a case of a conglomeration that has won investor favour with positive results over the last 4 years, led by Marchionne. But this 'turnaround architect' of FIAT's fortune is to leave Autos for Banking and serve the troubled investment bank UBS to do the same. However, whilst he has undoubtedly left FIAT all the stronger, he did pick-up FIAT Autos at the bottom of its cyclical trough, and it didn't require strategic and tactical brilliance to get back on track aided by major GM assistance, Ford partnering and provision of a good small car line-up and exploitation of the iconic 500. He is now leaving at what could be argued as a FIAT Autos peak, the task of the next CEO far harder as FIAT fights the international battle and suffers from a growing hyper-competitive home-market and European backyard. Relations with TATA and Chery will undoubtedly assist in reducing vehicle programme costs and accessing EM regions, but any interest in Volvo would need to be ideally mutually beneficial to all increasingly important partners, like the Jaguar platform conjecture for Maserati. Perhaps Volvo's acquisition could also aid the business cases for Alfa Romeo and Lancia, and piggy-back Volvo's international market presence (esp USA), but that 'fit of mutuality' would be critical.

Lastly from the Trade-Buy angle, this leaves the Indian and Chinese manufacturers – the big players like TATA, Maruti and Mahindra & Mahindra, aswell as SAIC, FAW, Dongfeng etc. The likes of TATA and SAIC have proven themselves to be M&A protagonists in the premium sector and are presently continuing to absorb their acquisitions. Both MG-Rover and Jaguar-Land Rover were bought for their base technology and future IPR potential as much as their upscale brand names.

Volvo would need to prove itself a compelling buy that could be easily absorbed into the host organisation, and with what are essentially major FMC hardware and political ties. Of the Indians and Chinese, given economic slow-downs in both countries, it will only be the cash rich and heavily committed that could make such move. Of the aggressive players, it is perhaps only TATA who, now experiencing that complexity of M&A transfer from FMC, is best positioned to managerially undertake such a venture. But credit analysts such as S&P and Moodys had already downgraded TATA for taking on too much risk and incurring deferred earnings when it acquired J-LR, before the real bite of the credit crunch. Another major distraction renewed focus on the Nano project's present manufacturing concerns. And it will be noted that whilst Jaguar, Land Rover and Volvo share similar market-segment territory, their respective construction techniques are markedly different and in the short-term hard to merge - Volvo's higher volume conventional (FMC) steel-based platforms vs Jaguar - Land Rover's aligned advanced construction solutions. So whilst there are undoubted product synergies to be had in the longer term, the 3 brands spanning cars and X-overs, the macro-economic issues of the here and now look to make even an under-valued Volvo as a stretch too far for the redoubted Ratan Tata right now.

Looking at Private Equity, one argument that could be theoretically constructed is that Tracinda (individually or as part of a consortium ie Arabic or Asian SWF) looking to take advantage of Volvo potential relative to an over-stretched Ford empire focused on its own core operations. Such an approach by Tracinda could, given its political clout with a Ford invested SWF, seek obtain Volvo Cars at a bargain Fire Sale price. Jerry York, could well be eyeing-up Volvo for Tracinda's own uses, knowing it would secure Ford's 'guaranteed' operational support (in procurement & development services) as Volvo Cars transforms into a legally independent entity.

However, if Volvo's unsecured future persists with FMC's increasing loss of patience and a PE consortium failure to grasp the mid/long term potential at a reasonable price, the ultimate arbiter could well be the Swedish government itself. Today's centre-right governmental stance will be an important factor in how the company is able to move forward. Unlike far more socialist predecessors this government unsurprisingly takes a far more capitalistic attitude but appreciates its responsibilities to its people. That a once semi-protectionist Sweden is today recognised as meshed within global trade; whether that be mobile phones, medical devises, vehicles or indeed the corporations that produce these products and associated services. Thus, whilst full nationalisation of Volvo Cars would not be entertained, it may well consider the idea (if presented the problem) of a government assisted initiative to ensure a domestic LBO/MBO could be undertaken. Done so if necessary to rebuild the company if, at worst case scenario, Ford did indeed asset-strip core capabilities that would take time and support to rebuild.

Ironically, this could well be a negotiation tactic used by Odell to gain governmental flexibility to 'help' Volvo during these dark days for Ford and Detroit; recognising Sweden's desire to maintain its national base of upscale car companies. Enterprises that have done much to put the Scandinavian country on the global stage over the last 50 years and commercial engines that add so much to the national economy.

But the reality is that presently, premium saloons, station wagons,, coupes and X-overs like the S/V-80, S/V-60, C-70, XC-70, XC-90 and possibly even upcoming XC-60 have been hit hard by the broader economic malaise. Sales forecasts are 400,000 units for 2008, down more than 12% from 2007's 457,000 units. The prime US market is down 23% YoY and down a hefty 49% in August alone. And whilst the smaller vehicles such as S40 and C30 were introduced their performance has been patchy, the S40 well received, the C30 far less so.

Thus Ford will have a major job of evaluating both the “Cost-Benefit” and “Opportunity Cost” of retaining or divesting of Volvo. It all too well knows the frustration that in today's Eco-orientated world, encompassing society's & the consumer's return to family values & community spirit, that the Volvo brand is indeed a gem. The problem, as ever under financially pressured periods, is the cost in terms of commitment, time and of course finances that it takes to polish that gem and make that emerald sparkle green.

Wednesday, 10 September 2008

Industry Structure – China – From the Running Red Hot to Post Bubble Blues to the Opportunities Therein.

Whilst China captivated the world in the run-up to, and during, the Olympics, there have been many observers – from the Beijing Street-Hawker to Wall Street Trader – who have wondered how the economy would fare once the massive public expenditure programme ended. That programme preserved a level of social and fiscal confidence within the country since the domestic stock-market highs this time last year (with P/Es at 25-35) turned to massive down-turn capitulations in sector after sector..

For all the talk of normative corrections, setting stocks back on more conservative and realistic ratings, the once ravenous appetite that underpinned Chinese growth as state assets became privatised appears to have largely diminished. Many planned IPOs have been shelved or post-poned, only the very secure (such as railways and infrastructure) now welcomed by overtly conservative private investors recognising the importance of central government's essentially guaranteed funding plans.

Thus it seems that China is reflecting the dynamic of western markets of the last few years, now looking at low-yield, long-holds as the safest of bets in what's become a risky and volatile capital market, drastically eroded by formidable inflation a 12 year high. Inflation that in turn is adversely affecting operational profitability across the board, especially so for those industries with heavy CapEx, overhead, raw material and staffing costs.

Unsurprisingly so, from the consumer's perspective, that jittery socio-economic climate has been most recently evident and most forcefully felt in the auto-sector; as sales figures for August revert to the levels of 3 years ago. Locally based consultants state that the August figures are the result of the public's Olympic focus, and that 'normal service will resume' as new models and incentive packages arrived at end Q3 & through Q4.

However, there may reason to argue that after what has been a long period of over-incentivised sales, applied not only to older models but also to new, that the new car market (in qualitative sentiment terms, if not in quantitative statistics) has effectively been saturated. Also note that the voracious Chinese consumers have been quick to re-purchase newer vehicles at the 2 & 3 year mark, recognising the value of the deals on offer, but also inadvertently swelling nearly-new used car ranks and so in turn promoting the vicious spiral of undermining new car prices. Since there has been little bounce from the stock-market downturn consumer confidence has been slowly diminishing, no matter how highly anticipated the grand Olympic event.

Reviewing the year to date, CAAM stated average sales by mid year rose by 'only' 14.3% compared to a previous forecast of 20%. By August that figure was a rise of 13 percent [4.55m units]. Of course mid-teen figures would be magical in western markets. But in what has been a 'wonderland' of 25%+ growth in recent years, the expected slowdown to 20% (resulted as the volume ripple spreads wider but with less intensity) was unfortunately demonstrably over-optimistic. The law of diminishing returns hit harder than expected.

So in effect the Olympics, as a massive public works programme, only really served to try and delay and massage the downward rate of consumer confidence, having little real effect to re-invigourate the economy; even with the accompanying supportive use of fiscal policy directives that sought to revive faltered capital markets. Indeed, some of London's Chinese community saw the Olympics as a timely “smoke and mirrors” exercise to the world. And though a possibly overtly cynical view, it would make sense that the Communist Party might try and re-configure the prime elements & sectors of its industrial base whilst the world's attention is focused on the results of Chinese commercialism, and not the management of machinery behind the scenes.

So what does this mean for the Chinese auto-industry?

The critical element is of course the profitability of the general sector and the players therein, whether state transformed, JVs with foreign manufacturers (as the large producers are), spin-offs from other sectors (such as motorcycles & defence) or indeed privately backed newcomers.
In May 2004 the State Development & Reform Commission set out a new policy that would alter the face of the industry by an intended date of 2010. That ambition was the enlargement of domestic companies (through organic growth and via consolidation best exemplified by the SAIC-Nanjing merger) aswell as the forming of commercial relationships between domestic and foreign enterprises – a key aspect that stretches from the 1978 agreement between Beijing Jeep and Chrysler to the more recent one with Chery Auto.

These reforms were recognised as being necessary since the early part of this decade when it was understood that the economic miracle of rapid growth could not be sustained, especially since China relied so much on low-cost exports, and that other countries such as Vietnam, Kasakhstan, other ex Soviet regions and perhaps even North Korea, were placed as natural future low cost successors that could both generate internal growth and importantly attract foreign capital. Thus, to sustain Chinese growth in the long run, would need insightful economic management that both fiscally cooled and fiscally re-energised the nation as appropriate, increasingly relative to the global economy – even if the de-coupling theory was theoretically proven.

Thus the natural evolution of the auto-sector would witness its rapid rise / expansion, induce competitive forces which, in turn, would degrade margins. This along with the desire to plan the sectors direction for both vehicle and parts-makers (set on a world-stage) would effectively demand sector re-structuring before / by / soon after 2010.

investment-auto-motives posits that over the last year since the severe Beijing & Shenzen stock-market downturns that China, masked by the hype of the Olympics, is a watershed period for Chinese industry, across many sectors from mining to steel to autos to the ultimate ambition of high-value specialisms.

As publicly listed corporate prices remain low, with the potential to drop further in the short-term under operating pressures, well see an eventual swath of auto-sector M&As, very possibly reflecting recent events in Europe. The Schaeffler acquisition of Continental and Porsche's buy-into VW could be models by which private entities (whether trade, family or PE) procure very tempting targets that can either be: a) synergistically absorbed into the holding company, b) bought as undervalued concerns awaiting the upturn or c) bought with divestment or spin-off potential.

Beyond potentially undervalued listed companies more easily available to foreign interests, there is also potential for progressive smaller local firms to seize the opportunities of mergers, or at the very least, alliance relationships. As we've stated previously, that could be formed from many different strategic perspectives, specific to: volume efficiencies of same car models / architectures, vehicle portfolio expansion using eachother as OEM suppliers to 'fill-in' respective ranges, to simply looking at operational functional advantages utilising eachothers differing core competancies.

Of course the possibilities are not simply restricted to more the obvious horizontal dimension of the sector, but also vertically, where upstream suppliers or even downstream distributor-retailers seek to maximise value-chain efficiencies via logically justified acquisitions. As with Japanese and Korean forebears it is often the stronger but invisible parts-suppliers that have the financial muscle to catalyse the lower orders of the more visible weaker car-makers in the industry.

And from the financial philosophical viewpoint, between the high profile listed corporations and myriad of smaller local firms are the likes of Chery and its peers, itself well placed and ambitious with plans for 42 new models between Q208 & 2015. These able and growing firms that appear to have attained the best of both worlds from 100% Chinese ownership (and its attendant political connections) to the technology sharing being accrued from production agreements with the likes of FIAT and Chrysler on mid and small cars.

Rationalisation spreads beyond strategic and capital expenditure concerns. There is a major need to address general productivity costs in this high inflation era, so just as commodities and raw material prices are slowly being tamed, so the thorny issue of wage cost inflation will need to be dealt with, very probably done so with corporations' judicious use of 2 arguments: I) reduced profits demanding input cost adjustment across the board, II) the natural effects of wage deflation as new transport infrastructure provides work access and opportunity to what were previously agricultural workers (as occurred previously). [We concur with a recent UBS/Economist report that counters talk of emerging restrictions on Chinese labour supply. Demographics and Land Reform policy and mechanisation will ensure supply well past 2025]

To this macro-economic end, domestic and foreign investors will be keen to assess the opportunities that both emerge and those that must be investigated and generated. Therefore, bankers in the China, Europe, the Middle East and US will be 'mentally plotting' each type of company relative to their prime referance points, or core strengths, that envisage a re-positioning in the shuffling sector. Re-positions that prove themselves to be aligned to the 2004 Reform Ideal...that being...

Under the Policies, the examination and approval system for domestic and foreign investment in car manufacturers is to be reformed into a dual system whereby certain projects require approval and others solely need to be filed for the record. The establishment of new sino-foreign joint ventures in automobile manufacturing requires approval by the SDRC. The Chinese party in a sino-foreign joint venture to manufacture complete cars, special purpose vehicles, agricultural transport vehicles and motorcycles is required to hold a majority share. If such manufacturer is a company limited by shares, one of the Chinese parties is required to hold a controlling stake that is bigger than the aggregate of the equity held by all foreign investors. Foreign investors in enterprises located inside export processing zones which manufacture cars and car engines for export may be permitted to have a majority share upon approval by the State Council. The Policies permit foreign investors to create two or more joint ventures in China to produce the same categories of vehicles, if they join forces with their existing Chinese partners to associate or merge with other companies in China.

A broad remit that has much scope for investment returns as the industry itself rationalises and thereafter takes advantage of a re-energised US & European opportunities as those economies pull out of their slump. Meanwhile, maximising the Emerging Market export & CKD possibilities that will be a strengthening thread before advanced market incursion.

Monday, 8 September 2008

Macro-Level Trends – Economic & Social Mesh – The Need for New Business Vehicles that Create Bridges to Optimism

As the mire of the current multi-trillion Dollar financial crisis keeps slowly unwinding, now contagion across the globe and yet to find a natural 'concrete' bottom various stakeholders are searching for the formula that will stem the decline.

It is generally accepted that the key is in understanding the construct and nature of risk present in the very complex, multi-tiered and heavily traded US mortgage market, so that confidence can be put back into investment decision-making and the banking sector can finally arrest the spiraling trend of quarter after quarter write-downs caused by having to bring back onto their balance sheets the nebulous financial instruments (eg CDOs etc) that are the eye of the storm.

Of course there are those (mainly large PE firms) who are buying the risk off of the banks at well below par, giving banks some added 'firm finance' and of course seeking sizable returns of their own – effectively betting that the “America Inc” will in turn provide market security and confidence. And with the Fed's effective takeover of Freddie Mac and Fannie May, that's precisely what has happened.

Whilst the Fed has intervened over the last year with 2 emergency interest rate changes, injected liquidity and 'guidence' of Bear Stearn's disposal, it had tried to appear as uninterfering as possible and tried to maintain an 'open markets' stance, only acting where necessary and with only with a light touch. That attitude some argue has led to little consequence - as with the lacklustre effect of the previous $600 per head tax rebate.

[NB. as of 15.09.08, the Federal Reserve's decision to not underpin Lehman Brothers, yet increase the collateral acceptance terms for lending to other banks demonstrates the fine-line it is having to walk to assist yet not prop the US's capital markets]

As the theory posits, in a global economy and market where information and capital flows instantaneously, a 'natural bottom' will eventually be found from which the US economy, and latterly the world economy, can rebound. But that 'natural bottom' is perhaps harder to find than anticipated. This exemplified by the LSE's very jittery movements last week before the Fed's announcement and the resultant massive 199bp leap today 08.09.08 before an IT problem halted over-frenzied trading. Hence Treasury Secretary Paulson's and the FHFA's Lockhart's decision to create a temporary stop-gap through the major assistance measure.

But for all the financial engineering that is being created behind the scenes to 'seize the opportunities within the present challenges', it is generally recognised that a further 18 months will pass, and perhaps longer given the core role that Freddie Mac &Fannie May play – and indeed its own outcome - before the seeds of growth (initially apparent in the commercial sphere as opposed to consumer world) will sprout. Realistically that means at the very earliest 2010 for business to start the value-creation trickle-down in society and the beginning of a re-bound in the housing market – the price of which may well have fallen on average 20% by then from its Q207 high. The general housing fall-out compounded by wave after wave of small-time landlords off-loading their property holdings as they decrease in capital value and annual yield; a trend occurring from Los Angeles to London to Lisbon.

The case is of course that across the US, UK, Europe, Japan and Australia that, even with incentives like Gordon Brown's temporary stamp duty concession, potential buyers with increasing living costs and new threats of unemployment (as seen by the US's recent 6.1% jobless reveal) are effectively in a state of limbo, lacking confidence to buy into their 2 biggest life purchases – houses and cars.

The evidence is clear: the US faces an annualised autos sales figure close to a lowly 14m units, the UK experiences the worst August sales environment since 1966 down 18% (the SMMT predicting a further 10% fall) and European sales fell 16% YoY in August.

Today automakers and the investment community are querying just how to deal with the situation beyond the down-turn norms of sector contraction, consolidation and alliance-forging and asset disposals. All of which make for new value creation, especially with the possibilities of full-scale sell-offs or commercial agreements with highly liquid foreign parties which, along with the flight from now risk-laden oil speculation, are helping to repatriate foreign dollar reserves back into the country.

However, whilst FDI and new latter-year ventures are welcome, both parties (bankers and automakers) should understand that such a momentous period of social and economic stagnation – the worst in 60 years according to Alistair Darling – also has embedded commercial promise if approached and executed properly. That means stepping back, philosophising and visioneering short, medium and long-term futures that may well co-related the utility of mobility and housing.

investment-auto-motives appreciates the enormity of getting the American and advanced countries' economies back on their feet, and the socio-economic effect that starting-over will have. (Unlike the EM / BRIC economies that simply face a periodic slow-down). The west is undergoing a major turnaround scenario that could possibly radically change the face of the population's perceptions – hence the calls from certain political corners for a re-focus on the human-centric measure of “GHP”(Gross Happiness Product) as opposed to the economic-centric GDP (Gross Domestic Product).

And it is this social re-alignment that takes place whilst the western economies are very slowly bottoming-out and picking-up that holds potential for advanced thinking commercial entities, devising new pertinent business models that offer combined 'holistic' products and services that satiate people's domestic and mobility needs within singular solutions, that give the populous a bridge (of high commercial profitability) to access future better times when they return.

Such visioneering will demand a merged concentration from both sides of the commercial equation, capital backers (leveraging their own business networks) and the still massively powerful and influential auto-industry. For it is at times like these that Creative Capital comes to the fore, for both financial fixed-income and quoted markets and the hard-pressed, but ultimately optimistic consumer.