Wednesday, 10 December 2008

Industry Structure - US Autos - Not Just Renovation, But Foundational Re-Construction.

Wall St has been laying out what they understand to be the central aspects and consequences of Congresses' plans to reform the Big 3 and the US auto-industry at large.

It is a common expectation, as parlayed by the banks bail-out, that shareholders face huge dilution as the government takes up to 20% equity (the details of which, whether 'preferred', 'common', 'convertable' etc yet to be seen). And senior tier debt-holders such as GM bondholders and UAW's VEBA are asked or co-erced to swap debt for equity. And so current investors, largely the institutionals, are concerned that the 'threat' of sizable new stock issuance, above and beyond the inherent rights of present common stockholders, will undermine their own interests.

Such an outcome where the real investors that propped-up GM (whether the likes of CALPERS or Fidelity right down to the individual Chevy loyalists in the public domain) suffer as consequence must be avoided. Any government, UAW and creditor stake-holder conversion must not split and pit one set of new investors against the interests of the incumbent believers who have hung on through the toughest of times and tested their belief in GM, American industry and American capitalism writ large.

And that phrase 'capitalism writ large' is the central message here. The core remit of the legislative and policy-making being written as the terms and conditions of the (possible first round) $15bn funding must create new sustainable belief. To do so it must create fertile foundations that encourage future capital/equity attraction to grow the strength of a new GM(-related) entity in whichever form(s) that may take.

Thus the government and present GM debt holders, must be put on par with the today's stockholders - no more no less. Do do otherwise would simply dis-incentivise the mass trading of the common stock, resulting in the a loss of 'life-blood' to the enterprise from not just US capital markets, but from those around the world.

Remember the massive levels of BRIC (esp Chinese) US$ foreign reserves and the Petro-Dollar based SWFs that seek 'defensive-sector' investment homes typically utilities, infrastructure, civil construction and autos - those core activities of Obama's US Revitalisation Plan.
And, crucially important, it is the growth demand by the common stock-holder that is the powerful driving force behind the dualist marriage so key to enterprise expansion: operational & budgetary efficiency linked with innovative exploratory thinking.

Thus the urge to segregate GM stake-holders into 2 camps must be denied, instead it should be alloted voting rights alone that provide a voice to the government, creditors and UAW.
This should be a top priority for any new incoming Car Czar (Pelosi suggesting Volcker), because by doing so it breaths much needed life into the NYSE, autos acting as a 'liquidity feeder' to other industrial sectors and so in turn boosting confidence; perhaps even as far as effecting the auto IT hardware & software product and service providers listed on NASDAQ. Putting investor confidence in a renewed GM, or seperately stronger divested parts there of, would provide a much needed ripple effect through-out the economy.

As for the future of Chrysler, it is obviously in a very different position since it is privately owned by Cerberus with Daimler's 19.9% remaining stake. Although certain lawmakers have attacked Cerberus for not putting more money into the company, the truth is that throwing money at Chrysler, such a marginalised player, would have not solved its ills and before the financial implosion there was no real need to. Chrysler's problem is primarily its strategic fit in the US & global markets, not its fiscal strength. The liquidity Chrysler already had was already being allocated to small and mid car programmes by the time Cerberus bought-in. However that small car strategy should have been undertaken far earlier to give Chrysler competitive advantage over GM and Ford. And although it chose the right path to undertake foreign JVs with Chery & FIAT, that process creates longer car-project lead-times given political and platform demand complexity. It defrays capital costs but also delays the timing of the resultant income stream that was needed far earlier as part of a self-sustainability mentality.

As investment-auto-motives recommended in mid 2007, Cerberus should have prepared to have fully divested Chrysler to a foreign suitor, via a structured phase by phase divisonal sell-off whilst the markets were liquid and foreign appetite high. That didn't happen, and honourably and rightfully the private-equity group has promised to forgo any benefit resulting from government aid to Chrysler. Though we suspect Daimler may well argue for partial access to the Chrysler monies if it can convince Chrysler and Congress that it intends to maintain its US-focused JV partnership, possibly coming to the technology and platform aid. In short the operational benefits of the previous D-C marriage without the legal and political intractability. Just how Chrysler will react to such a possible action depands much on its own strategic choice.

As of today (10.12.08) reports that Chrysler has ended its small car ambitions with China's Chery suggests that it has been convinced to seek either full Chinese control of that project, possibly taking a role as an end-buyer only of the car, a new JV with a Detroit peer is on the card (given GM-Chrysler alliance conjecture) or that the company (or its assets) as a whole is being reviewed for sale to external parties.

From an investment perspective Cerberus ended up between a rock and a hard place with Chrysler once the US and global car market demand plunged, the retreating tide demonstrating that it was indeed swimming naked strategically. Like much of the private equity world which has lost up to 40% of portfolio value over the last year, Cerberus will either be keen to exit Chrysler for the same price it bought its 80% stake - something looking less and less likely - so more probably look long term to seek mid term efficiencies advantage from US sector integration and far a more lenient UAW advocating recognised neededlow cost labour reforms and deferred/reduced VEBA contributions.

As for the Ford family, it will use this crisis to demonstrate the advantage of its own family-governance structure and 'in-tune' management that has undertaken a seemingly successful One Ford turnaround inititiave. As comparitively the most buoyant, thanks to Mulally's 'large re-mortgaging loan' against Ford assets (at what was an asset high-value watermark) it has stated that will not need the short-term emergency loans but may want access to government funds later. That fiscal position plus ongoing cost-savings, the probable sale of Volvo, a good incoming US product mix with high % of small and compact and critically no government 'interferance' that creates ROI drag for investors perhaps continues to best places FMC in the eys of Wall St and the world.

The tug-of-war between politicians and executives regards the capability of that has emerged over GM’s board & senior management has set the Congressional cat amongst the Detroit pigeons; urging a shake-up as condition of government financing. But whilst Detroit contends that GM is on the right track and its problems stem from economic forces, not poor management the truth is that it should have been acting more like a far more 'in-tune' Ford, when it was in fact acting like Chrysler with such an addiction to the high margins of SUVs created by what were obviously overly massaged credit conditions. Ironically given that GMAC itself was a participant of sub-prime lending offering ridiculous deals with far-off breakeven periods, should have created inter-company dialogue that prepared GM for the inevitable snapping of the over-stretched elastic credit band.

Whilst the pressure for fresh blood is less intense at Ford, Chrysler should not be left off the hook of examination, but who really is to blame? Very probably the Daimler-Chrysler divestment process, since much would have been at standstill as the big picture issue of finding a new Chrysler buyer by typically prettying-up the operation for sale and stemming budgets to hoard cash for the balance sheet took precidence. The executive angst of redundancy was palpable and undermined the desire and ability to properly plan; a great shame when seniors more than ever needed to be operating better than ever.

Today, Job losses will continue carmakers adjust capacity to present demand and the new 'Car Czar' looks a much diminished near-mid term sales demand future. That opportunity to re-structure for a brighter tomorrow muct be recognised by the blue-collar staff who whilst feeling so low must open their eyes to the reality of what has been an over-blown, overtly comfortable and now defunct US automotive business model; a dinosaur model created over 60 years ago in a very different age. Yes the UAW made increasing concessions year on year but the tide of change grew to an unstoppable tsunami.

That means the government will need to set labour rates and conditions at parity pay levels to the 'cheap labour' that has assisted the competitiveness of largely foreign brand automakers' that lie below the Mason-Dixie line. To do so Obama and his economic advisory team will need to convince 'John the Line-worker' just how different, and industrially hungry, the world is beyond the US borders. Whilst John moans of the Mexican story of work translocation, he must be fully educated to the realities of how the Big 3 can and do operate in BRIC regions and beyond into new emerging territories. So even the UAW's agreed two-tier wage structure under which new recruits are be paid $14.20 vs $26.00 per hour will need to be extended.

But whilst the Big 3 will continue in one recognisable form or another, it will be the supply-base that requires greatest consolidation and efficiency creation. It is essentially a nationally complete value chain, created by the likes of Henry Ford and a myriad of family enterprises backed by understandable government ideology and policy of the time. It of course has been remoulded over time, but the plethora of businesses operating at very low profit margins still evident today highlight the systemic inefficiencies of the complete value chain, each party trying to eak-out its slice from a cake of finite value. As we've seen over the last few years, too many parties slicing the a diminishing cake too thinly leaves nothing but crumbs. Not a sustainable diet.

The same is of course true for the massively sprawling, inefficient dealer base, created by the constant previous amalgamation of delaers representing the likes of Fraser, Nash, Willys, latterly American Motor Corp etc etc. All three carmakers have told Congress that they will trim dealer networks, GM axing 1,750 outlets over the next four years, but even then, it would have more than three times the number of Toyota, which is only slightly behind in market share. With fewer brands and a naturally declined attritional market share, that x3 figure will prove too many and so once again encourage price warfare and value destruction amongst the survivors.

That would of course hit GM's profitability and so an eventual return to the problem today. The dealers, well-connected and politically powerful, are protected by state franchise laws, and these require changing. As the FT reports, GM paid out $1bn compensation to dealers after abandoning its Oldsmobile brand in 2001. It could afford it then but not now and definitely not at the taxpayer's or new investor's expense.

Instead, there will need to be a push for regional consolidation where old dealer foes will need to work in unison to merge and re-generate their combined businesses. GM's and Chrysler's delay and cancellation of pipe-line vehicles should allow proprietry and dealer car inventories to whittle down over time and allow for that transition. The quicker they realise that and act to present themselves as part of a renewed, invigourated schema or plausibly elect to leave the US brand fold and take on franchise deals with the likes of Hyundai, Honda, VW etc the better.

The future emphasis smaller cars that will imbue higher cost technologies, from direct injection diesel to plu-in hybrids in the challenge to gain fuel efficiency, meet CAFE regulations and reduce CO2. This in turn means that profitability for supplier-base, VM and dealer will be gained from the leverage of greater volume for single platforms (over 4m becoming the norm) with less model variants and less specification configurations, allied to larger, higher output sales environs, that focus as much on the service and through life experience that both reduced costs and improve pricing abilities with novel new technologiy and usage-method options.

A viable, indeed prosperous tomorrow is attainable, but it needs a massive re-adjustment of sector perceptions and practices to reach it.