The Current State of the U.S. Auto Industry
Not bailing out Detroit would be a disaster for the U.S. auto industry.
As of the time this article is being written, General Motors (GM), Ford (F), and Chrysler LLC (the Detroit 3) have just submitted proposals to Congress and testified justifying why each firm deserves government aid. Assuming no private sources of capital or government aid appear, GM and Chrysler will be forced to file for bankruptcy this month. Ford has more time but is heading down the same path. This situation is very fluid and the outcome is very uncertain, but whatever happens will have a large impact on the entire automotive supply chain. The outcome for the Detroit 3 will likely take one of three forms, which we discuss in turn.
Option 1: No Assistance--Followed by Bankruptcy
First, if the government does not provide any assistance, GM and Chrysler will likely file for Chapter 11 bankruptcy. This could quickly lead to Chapter 7 liquidation as neither company has enough cash to operate in bankruptcy for very long. This outcome would be the economic equivalent of dropping an atomic bomb in the U.S. manufacturing sector. A Nov. 4 study by the Center for Automotive Research estimates such a scenario would cause 2.5 million jobs to be lost throughout the entire U.S. economy; over three years, it would cost the private sector $275.7 billion in lost personal income and would cost the government $108.1 billion. Bankruptcy in GM and Chrysler could cause Ford's distress to accelerate as supplier failures would hurt all automakers. Ford and GM have 80% supplier overlap and even healthy companies such as Toyota (TM) and Honda (HMC) use some of the same suppliers as the Detroit 3. This outcome is the least likely outcome, however, as we do not think the Obama administration will want to put more factory workers in key electoral states out of work, and Speaker Pelosi stated on Dec. 2 that bankruptcy was not an option.
Option 2: Bankruptcy, but With Government Financing
Despite Pelosi's rhetoric, Congress has explored forcing a prepackaged Chapter 11 filing for at least GM and Chrysler, with the government providing debtor-in-possession (DIP) financing. On the surface this sounds like a good move. Bankruptcy law would give the automakers more leverage over the United Auto Workers (UAW) union and suppliers, and it would make dealer closings easier by allowing the automakers to get around state franchise laws that tend to favor dealerships and their many in-state jobs. Beyond these issues though, bankruptcy becomes far more complicated and is not a good option. Each Detroit 3 firm has many stakeholders (creditors, stockholders, unions, retirees, dealers, financing arms, vendors, warranty holders), and getting this many parties to agree on terms ahead of a filing would be cumbersome if not impossible. The longer a bankruptcy lasts, the more taxpayer money will get used, because only the government would be willing to provide DIP financing. Chrysler's plan claims the company would require $20 billion of DIP financing in a Chapter 11 filing just in the first year. Thus, taxpayers could end up spending more than $100 billion supporting the Detroit 3 while in bankruptcy. The government, via the Pension Benefit Guaranty Corporation (PBGC), could also be forced to guarantee pensions at each company, which would be a huge strain on the agency.
Proponents of bankruptcy also are ignoring the risk that consumers may not buy a vehicle from a bankrupt firm. If this holds true, then no amount of government aid will avoid Chapter 7 liquidation. Governments and dealers can guarantee warranties all they want, but why should consumers trust a dealer saying the warranty is guaranteed when they do not trust the dealer already? The dealer could end up going out of business as its sales go down as well. Plus, there are questions as to why a consumer would even take the risk in the first place when there are plenty of healthy foreign brands to choose from. Industry research has found 80% of vehicle buyers would not buy a vehicle from a bankrupt company, indicating bankruptcy is not the path to viability some claim it to be.
Option 3: Reorganization
The third possible outcome is that Congress and President Bush agree to some modified form of the reorganization plans submitted by each automaker on Dec. 2. These plans avoid bankruptcy and will likely be approved this month, the form of which is very important to stockholders and bondholders of each company. As of publication, it is unknown if automakers will have a choice between the government aid being given as senior debt or preferred stock. GM's plan document said it wants preferred, as it "creates a more effective platform for GM's future capital raising activities." Ford did not make this request but has requested that its government loan sit above unsecured creditors but below existing senior creditors so as to avoid a default on existing debt. There is no way the government is going to agree to be second in line to any other party, so this will likely be a source of contention on Capital Hill. Draft legislation prepared on Dec. 8 states the financing would be in the form of loans, and that the government will be senior to all creditors. This is unlikely to change because the automakers are not in a position to bargain.
In order to give taxpayers access to the upside of any recovery, the government will likely attach common stock warrants to any debt or preferred stock it issues. The key matter is how dilutive will these warrants be. If they are as dilutive as they were for American International Group (AIG), Fannie Mae (FNM), and Freddie Mac (FRE), then common stockholders will essentially be crowded out by the government's equity stake, and GM and Ford shares will trade like out-of-the-money call options for years. If the warrants are comparable to the dilution limits set forth in the TARP package (as Ford has asked), then common shareholders' dilution will not be as severe. Because wiping out common stockholders of GM and Ford will not hurt the stock prices of their parts suppliers (bailing out the Detroit 3 in any form would likely boost share prices of other auto firms) the government has little incentive to not crowd out GM and Ford shareholders. Still, the government may not make the warrants very punitive, because their role is one of lender of last resort rather than one of profit maximization. The draft legislation from Dec. 8 calls for the warrants to be equal to 20% of any aid provided. Ford had requested no more than 15%. Twenty percent is not as dilutive as situations such as AIG, but it would still be a very large dilutive stake. In GM's case, for example, the government would own about 63% of the stock, assuming GM borrowed the full $18 billion it may need per its restructuring plan.
Even if the government provides loans this December to avoid bankruptcy, the Obama administration will likely have to create another aid package at some point in 2009. Auto sales are unlikely to rebound next year, and the cash burn rates of these companies suggest that the money they are asking for is not enough, despite claims to the contrary. Chrysler asked for $7 billion just to get through December, but there is no indication that it will have sufficient capital for very long into 2009 unless Cerberus is planning to kick in more capital. GM claims it can pay off all the loans by 2012, which seems very optimistic given its cash burn. Also, all of the companies have to hope they can quickly reverse the perception of Detroit's quality gap. Too many Americans gave up on Detroit after bad experiences in the 70s and 80s and are now firmly loyal to a foreign brand. Reversing this trend will likely take an entire generation.
Impact on the Rest of the Supply Chain: Suppliers and Dealers
Assuming a government aid package allows the Detroit 3 to avoid bankruptcy, the automakers' plans still call for them to become smaller companies. Less production and less vehicle sales of American brands will impact the rest of the supply chain, specifically parts suppliers and dealerships.
Suppliers to the Detroit 3 are divided into three tiers. Tier 1, which are most of the parts suppliers covered by Morningstar analysts, are firms that supply parts directly to the automakers. Tier 2 and Tier 3 suppliers are the next two levels in the supply chain and tend to be much smaller than the Tier 1 firms. With less production coming from the Detroit 3, parts suppliers will have to consolidate because there will not be enough volume to support the supply chain in its current form. Parts suppliers that have highly leveraged balance sheets and/or derive the vast majority of their revenue from Detroit 3 firms are likely to liquidate in 2009, as their revenue will fall too hard and too fast to remain profitable (and in compliance with debt covenants). Over time, foreign automakers will add capacity in the U.S., but that will not happen fast enough for some parts suppliers to offset their losses from Detroit automakers.
Tier 1 suppliers with leading market shares and healthy balance sheets are best positioned for the new American auto industry. Firms such as Magna (MGA), Johnson Controls (JCI), Autoliv (ALV), BorgWarner (BWA), and Gentex (GNTX), are some of the players best positioned to thrive once auto production increases. Another benefit of keeping Detroit in business is that suppliers of both content and design can stay in the United States. Johnson Controls and A123Systems are both American companies that have significant businesses in lithium-ion vehicle batteries. If the Detroit 3 failed, most lithium-ion batteries would be procured from Japanese companies such as NEC and Panasonic that already have partnerships with Japanese OEMs. It is important to note that many Tier 1 suppliers in the U.S. are highly levered and may not survive 2009. Even with a government bailout, many Tier 2 and Tier 3 names will go out of business, which will disrupt the automotive supply chain for all of 2009.
With fewer fixed costs than manufacturers and very profitable parts and service businesses that bring in revenue during declines in vehicle sales, auto dealerships are generally fantastic businesses--but they're not immune from the current downturn. Almost all U.S. dealerships are privately owned, and the ones most at risk of failure are the ones that primarily sell Detroit 3 brands. With the Detroit 3 losing market share each year and each firm closing dealerships (GM seeks to reduce its U.S. dealer count by 27% by 2012, for example), survival favors the larger more diversified dealers who can stay profitable even in this terrible sales environment. Many privately owned Detroit brand dealers make a small profit per vehicle and rely on volume. This model does not work when credit to buy a car is restricted and a brand a dealer sells is in decline. Publicly traded dealerships are large enough to generate economies of scale that many small dealers do not enjoy. According to statistics from The National Automobile Dealers Association (NADA), since 1988 the number of U.S. dealerships with annual new vehicle sales less than 400 units has declined 42.5% to 8,563 from 14,890 while the number of dealerships selling over 400 units has increased 20.4% to 12,207 from 10,136. The industry is clearly consolidating in favor of larger volume dealers and will continue to do so as Detroit struggles and sells off brands. The larger dealerships can remain profitable enough to wait out this downturn in vehicle sales and will keep gaining market share in any sales environment.
An investor looking to make money on an inevitable cyclical rebound in auto sales could do well in the dealer sector. Although no one thinks about it now, a day will come when demand for vehicles is once again strong. Morningstar estimates that 2008 new light-vehicle sales will come in at a ratio of about 1 sale for every 23 Americans. On a per-capita basis this ratio is far lower than the average since 1997 of about 1 per 17. As for 2009 sales, Automotive News, the leading industry trade journal, says that the last time predicted per-capita sales were as low as they are for the next year was 1961's 1 per 28 Americans. Sales are likely to stay in the trough for longer than just the down year seen in 2008, but the current levels are well below where they should be. The U.S. is a bigger country than it was in 1961 and the U.S. is very much a car-dependent society, so there is no reason to believe current demand levels are normal. With sales well below normalized levels, much pent-up demand exists from consumers delaying a new vehicle purchase. When the consumer returns to the showroom, investors in dealer stocks who were patient enough to wait for the recovery will be rewarded. Good stocks to wait out the recovery are the stronger dealers such as AutoNation (AN), CarMax (KMX), Group 1 Automotive (GPI), Penske Automotive Group (PAG), especially when they are trading below Morningstar's Consider Buying price.
The auto industry is going through unprecedented distress and the future is very hazy. There are good auto stocks out there, but even these will suffer enough volatility to make them not suitable for every investor. In its last earnings presentation, Group 1 cited market research by CNW that sales levels in the recessions of the early 1980s and 1990s remained depressed for three and two years, respectively. This fact means that although a recovery will come, investors will likely need to be very patient. And if the Detroit 3 liquidate next year, 2009 will be nothing but chaos.
David Whiston does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.