Can Detroit Be Retooled — Before It’s Too Late?

The automobile business is great. Just ask someone who’s in it. “People want to buy cars,” says Rod Buscher, CEO of Summit Automotive Partners in Denver, which owns 30 assorted dealerships nationwide. And he really wants to sell cars. The problem is that would-be buyers lack either the income or the access to credit that would allow them to drive a new Malibu or Lincoln or Camry off the lot. That won’t last forever; in fact, the automobile business figures to be good in 2011 and terrific in 2012–which also happens to be an election year.

The question is whether any U.S. automobile manufacturer will live long enough to enjoy it. President Barack Obama would rather bridge General Motors to the future than see it collapse, but he has now made it clear that the GM we know and don’t really love is finished. So is GM CEO Rick Wagoner, who was told to hit the road, his three decades of service to GM–and strong support within the industry–now considered a liability. “This is not meant as a condemnation of Mr. Wagoner, who has devoted his life to this company,” Obama said in condemning him. “Rather, it’s a recognition that it will take a new vision and new direction to create the GM of the future.” In Wagoner’s place, the President promoted COO Fritz Henderson, who has worked at the company for 25 years. Henderson gets the message: “One, go deeper, go harder; and second, go faster. And so we got it. We understand exactly what that means.”

The to-do list presented to GM by the President’s auto task force is stark and steep: shrink labor costs, including retiree health-care expenses; slash debt; kill or sell low-performing brands; and reduce the number of models for sale and the number of dealers selling them. Should GM, the United Auto Workers (UAW) and the company’s bondholders fail to figure out how to execute those tasks by June 1, the government will usher GM into bankruptcy, which could lead to its breakup into “good” and “bad” subsidiaries. The bad would be sold for parts.

In that sense, GM is getting off easy: Obama’s task force gave Chrysler just 30 days to seal its proposed partnership with Italy’s Fiat Group–or else join the likes of American Motors, Packard and Studebaker in the auto graveyard. If Chrysler gets the deal done, the government will lend it $6 billion to sustain its operations. But Chrysler’s owner, Cerberus Capital Management, will leave with zero of its $7.4 billion original investment.

The landscape of the U.S. auto industry, in other words, is about to be radically reshaped. So what will its future look like? It’s difficult to imagine today, with consumers hunkering down, car loans drying up and the Detroit Three struggling to survive, but the global car business may be on the verge of a big upswing in demand. Companies that can meet consumers’ needs for fuel-efficient yet stylish cars–and that have flexible manufacturing plants to turn out the hot products on demand–are likely to find huge opportunities for growth once the economy recovers. That’s partly why there’s so much riding on the Administration’s plans to revamp GM–and why it had better happen fast. If U.S. automakers don’t take advantage of the coming car boom, the rest of the world will.

First Things First

Before planning for the future, however, Detroit still has to get through the present. GM has been on life support since Dec. 19, when the outgoing Bush Administration threw it a short-term loan and told the company that it had until March 31 to come up with a plan for its long-term survival. It did–but its strategy was premised on projections that car sales would begin to pick up this year after last year’s dismal industry performance, in which sales sank 18%, to 13.2 million units. But the pickup hasn’t happened yet, and analysts see the industry’s production “run rate” at or below 9 million units.

Even worse, in the eyes of Obama’s task force, is that GM was immodest in its assumptions. For instance, GM had forecast a market-share loss of 0.3% per year until 2014. The task force noted that GM has been losing market share at a rate of 0.7% per year for the past 30 years–and GM was planning to drop brands and nameplates. The task force had no reason to think that GM could gain share, and its sales rate proved that point. Industry-wide, March auto sales were down 40% on a seasonally adjusted basis. GM’s factory-utilization rate is less than 60%. That’s abysmal–the rate needs to be in the 80s for the company to be successful–and it’s one reason GM is hemorrhaging cash. “We don’t believe the rest of ’09 will be strong. We are going to stay soft through the rest of the year,” says Lars Luedeman, director of analytics at Grant Thornton, which follows the industry. Dealer inventories are approaching a 100-day supply; 60 days is more typical.

The White House’s auto-task-force working group is headed by Steve Rattner, a former reporter who was head of the private-equity firm Quadrangle Group, and Ron Bloom, an investment banker who previously worked for the United Steelworkers union. Staffed by about 15 restructuring and other experts, the task force aims to do two things in the weeks ahead. First, it will try to close the deal on Chrysler’s sale to Fiat. Sources familiar with the task force’s approach describe Chrysler as “hollowed out” by a succession of owners and largely worthless, with no quality brands other than Jeep and little hope of restructuring itself into a viable concern.

Bloom has taken the lead in trying to negotiate the sale of 20% (at least initially) of Chrysler to Fiat. His position has been undercut by Chrysler’s tenuous finances, leaving Fiat holding the cards at the negotiating table. The $6 billion sweetener from the government essentially amounts to a dowry for Fiat to take the ugly bride off America’s hands.

The harder job facing the Administration comes when the 60-day window is up for restructuring GM outside of bankruptcy. The biggest challenge for GM remains fashioning a plan acceptable to the UAW, which represent GM’s 62,000 workers, and its bondholders, mostly banks and other large institutions, which are owed some $27.5 billion and by law are first in line to get paid back. It’s fairly clear the Administration wants to make bondholders eat huge losses–or make them try their luck in bankruptcy court. “No bankruptcy judge is going to rule against GM and its plan. Not for labor, not for bondholders, that’s for sure,” says Lynn LoPucki, a bankruptcy expert at the UCLA School of Law.

Should GM go into bankruptcy, the plan would involve forming one company around bad assets, such as Hummer and Saturn, and dumping the retiree health-care liabilities into it. That company could be sold off or wound down. A second company would comprise the better performing Chevrolet, Buick, Cadillac, Pontiac and GMC brands. That ongoing firm could be partly owned by the bondholders, the UAW and other creditors.

The bondholders could try to resist bankruptcy, but there would be consequences. Among the bondholders are banks such as JPMorgan Chase and Wells Fargo that themselves have taken money from the government’s Troubled Asset Relief Program. Standing in the way of the Administration’s plans for the auto industry would win them few friends. One option the bondholders have is to try to seize the factories. But that would jeopardize the partsmakers too, and the banks are also holding the paper for many industry suppliers. If the factories shut down as a result of a legal battle, so would the partsmakers.

Even trickier for a Democratic Administration is telling hard truths to the union. On that score, Obama’s toughness has gained him some street cred in business circles–even drawing faint praise from a Wall Street Journal editorial. The task force has made it clear that GM can’t afford the renegotiated wage-and-benefits package the UAW agreed to in 2007. Even using GM’s best-case scenario, the company projected a negative net cash flow of $14.5 billion over the next six years. Most of that deficit can be accounted for in retiree health and pension benefits–which means that one way or another, the hundreds of thousands of UAW retirees are probably going to get a lot less health coverage. The outlines of a plan are likely to be drawn up by Bloom, a pioneer in the voluntary employee beneficiary association (VEBA) approach. In a VEBA, the union agrees to accept a cash payment to fund a new health-care system that trustees administer, thus taking future liabilities off the company’s books. That’s what happened at Ford, where the company negotiated a deal in which half the VEBA will be funded in the form of stock rather than cash. GM may need even more help.

Understandably, neither the union nor the bondholders are happy about the task force’s approach. The UAW feels particularly aggrieved because it has agreed to an unending series of givebacks over the past 20 years. Even before this latest crisis, the UAW had assented to the 2007 contract, which would have put Detroit’s labor cost per car within a couple of hundred dollars of Toyota’s and the other transplants’. That isn’t enough, in the view of the task force, because consumers are willing to pay more for the foreign badges, and the Detroit Three need to earn more on domestic car sales to become viable for the long haul.

The Coming Car Boom

Once the dust settles, the new GM, or whatever replaces it, is likely to see a marketplace of consumers finally ready to spend money on new cars. GM’s executives aren’t entirely off base in thinking that pent-up demand is building, because it is. “Assuming general economic recovery, in the developed markets we will see maybe 95% of what it had been,” says John Paul MacDuffie, an associate professor of management at the Wharton School of the University of Pennsylvania and an auto-industry specialist. U.S. auto and light-truck sales topped 16 million for eight years and reached nearly 17 million in 2004 and 2005. Those numbers have slumped dramatically, but the current downturn is cyclical, says MacDuffie; there’s no evidence of permanent decline in the demand for vehicles.

It’s true that we’ve been putting off buying cars for nearly two years as unemployment has climbed and credit has been choked off. (Showroom traffic is increasing, notes Summit Auto’s Buscher; it’s financing that continues to lag.) But that also means that we’ll be readier to buy when credit starts to loosen. Even if this recession lingers longer than expected, results will pick up substantially in 2011. Analyst Luedeman predicts that sales in North America will bottom out at 8.4 million units this year (others say slightly higher), then jump to 10.2 million in 2010, a 21% improvement. And by 2012 the industry will be in a full-fledged boomlet, at 13.8 million units annually.

Why are analysts so optimistic? History is an indicator of future sales. Eight or nine years ago, the industry was selling 16 million to 17 million units annually.

Now those millions of sedans, pickups and SUVs have reached the end of their useful life. America is becoming a rolling junkyard; the average car is 9.4 years old, a new record, says Buscher. “Light trucks are 7.5 years old. They haven’t been that old for 10 years,” he adds. In two years, says an industry economist, 35 million cars now on the road will be at least 10 years old. There’s not enough duct tape in America to hold that much junk together. Even if they don’t conk out, keeping these beaters going becomes an increasingly expensive proposition.

As a result, more cars are being taken off the road than are being manufactured. There are 245 million to 250 million vehicles on the road in the U.S., and roughly 5% are scrapped every year. Even with improved vehicle quality, that ratio is not really budging. Stuff wears out. So some 12 million to 12.5 million vehicles disappear annually; yet this year, no more than 9 million are being built to replace them. Next year, production will be 10 million or so, still less than the removal rate.

Using the industry metric, which estimates that about three-quarters of current sales are replacement vehicles, demand will push past 13 million cars by 2012. O.K., so assume that some people will drive less, run their cars into the ground or–gulp–give up driving. You still don’t lose much. What’s known in the industry as “density”–the ratio of vehicles to drivers–continues to increase.

That’s particularly important because the number of drivers is increasing. The U.S. population is advancing at a clip of 1% per year. But more important, the baby-boom echo is getting its wheels. Between immigration and the offspring of boomers now asking for the car keys, at least 2 million new drivers are entering the market every year. That invariably adds to demand.

Lastly, the auto demand curve is a leading indicator out of a recession. Any GDP growth will correlate directly with auto sales–until growth reaches 4%. At that point, sales growth then turbocharges to about 7%, if the past is any measure. Analysts insist that when you combine the replacement demand, scrappage rates, demographic changes and an economic recovery, there’s a case to be made that North American demand will approach 16 million units within five years. “We haven’t seen this kind of positive force in replacement demand for this amount for a while,” says the auto economist. And thanks to growing overseas markets like China and Russia, where GM is well positioned, industry growth outside the U.S. will be even greater.

It’s even possible, despite the current bleakness, that car sales will return to an upward trend this year. The prices of some used cars are beginning to rise as supplies tighten, which makes new cars a more attractive deal. Any improvement in the homebuilding industry bodes well for light-truck sales. And if Congress passes a proposed cash-for-clunker bill that would give car owners a $3,000-to-$5,000 voucher to trash their old vehicles and buy something new and shiny, dealers will move the metal, as they have done already in Europe.

Down the Road

Anyone who is in business in 2012 will get business. For all their problems, there’s no question that the Detroit Three will have some competitive cars. GM has already made the case with its award-winning Chevy Malibu. The 2009 Buick LaCrosse recently topped all midsize competitors in the dependability ratings of J.D. Power & Associates. That’s a positive sign, given that Buick is such an important brand for GM in China. Ford, which is in the best shape of the Detroit Three, has found success in its new Edge, in its F-150 pickup and in a global restructuring that will bring the best products from its overseas operations to the U.S. If there are new labor contracts in place, the domestic automakers also stand to be cost-competitive with the transplants, which will translate to more profit per car, even if selling smaller cars means fewer sales dollars.

A downsized, revitalized U.S. car industry will still be playing catch-up. Millions of car buyers won’t consider U.S. brands for some time to come; the perception that they are inferior lingers long beyond the reality that they are not. And foreign competition may increase: companies in Asia, such as China’s Chery Automobile and India’s Tata Motors, could plant their flags here. Established players like Volkswagen and Hyundai-Kia have plans to build plants in the U.S. by 2012. Which means the sales rate will be exceeded by manufacturing capacity, as it always is.

Either way, the car-buying public is the winner: consumers will see better-built, more fuel-efficient cars and trucks–gas-powered, electrics and hybrids–that will meet their every desire. Obama’s challenge is to make sure some of them come from Detroit.