VW, UAW

While I prepare a post on Mitsubishi Motors (I began going through financial statements a couple weeks back) let me point to a post by Jared Bernstein on ironies with the labor movement today. His contention is that we see pro-business, government-shouldn't-constrain us conservatives trying to constrain the ability of VW to invite in the union. Consistency is apparently for small minds. Behind the Veil

China: The Domestic and the Global Industry

In October 2013 sales in China reached 1.92 million units – see the China Auto Industry Association statistics page for details. That's just shy of a 24 million unit rate, and is surely the largest number of vehicles ever sold in a single market in a month. For GM, sales were 282,000 units – 25% more than US sales that month. Everyone is in the market, or preparing to enter there. The Korean neighbors (Kia and Hyundai, but also Daewoo as part of GM), Japan (or at least the Japan Three of Toyota, Honda and Nissan, and Mazda and Suzuki), Germany (BMW, Mercedes, VW), the Detroit Three and now the French, both PSA and Renault. A host of local firms continue, though most as paper entities. Still, Great Wall, Chery, Geely, BYD, Changan and others.

This raises a host of questions. I focus on two: geography and profitability. I frame my brief analysis using the perspective of the OEMs. Since more and more value added lies with suppliers, that may lead to inappropriate conclusions, but for now I will accept the status quo terms of debate.

...the geography of China's automotive industry makes no economic sense...

First, despite very large production volumes, a side effect of government policy has been to disperse production widely. Even though the Third Front policies of the 1960s are widely understood to have been a failure, the political economy of joint venture approvals has led to factories in locations that make little sense. Today, with the market supply-constrained, that matters little. As competition heats up, however, the costs that accompany scattered locations will become more and more burdensome.

Second, there's profitability. On a global basis, the dark secret is the industry depends on the US market for a disproportionate share of profits. Japan's domestic market is in long-term secular decline, and will remain fundamentally unprofitable despite the dominant position of Toyota. (Suppliers seem to be able to collude with impunity – or so they thought – but Toyota hasn't been successful in being a price leader.) Europe is little better, offset only because of a richer product mix. How profitable is China? To my mind that is the single more important strategic variable the industry faces.

Back to geography. Under Mao local governments were expected to fend for themselves, first and foremost in terms of food but extending to a wide variety of industrial products. Fearing a Soviet attack, Mao deliberately dispersed heavy industry into remote locations. So at the onset of post-Mao reforms, every province and most large cities turned out trucks and passenger cars, even if only a handful a year. In total there were perhaps 120 producers. But political power was likewise dispersed; up-and-coming party officials were rotated through a variety of posts, but anyone slated for top leadership served a stint as a provincial governor or mayor of a prefectural-level city such as Shanghai. To be promoted to the senior leadership in Beijing required presiding over economic growth. So when the government looked to joint ventures to improve motor vehicle production, the result inevitably was one factory here, another there. Local protectionism – in Shanghai you found old generation VW Santanas, in Beijing you found jeeps – reinforced this desire to have your own plant.

China has no equivalent to the 600-mile-long I-75 "automotive alley" in the US, with an agglomeration of suppliers, assemblers and associated engineering centers feeding off of each other in a positive manner. Beijing is 1,300 miles from Guangzhou [Canton] in the south, and several automotive operations are another 400 miles to the northeast of Beijing. Similarly, at the western end of the zone is Kansas City, 700 miles from Detroit and 650 miles from Columbus, OH; Chengdu in the Sichuan basis is 1,200 miles to the west of Shanghai, across rough terrain, and Urumqi is 2,400 miles away.

Perhaps Wuhan will become a nexus – a recent Automotive News China story – but there is none at present at the assembler end. Perhaps suppliers are more concentrated, I know of several engineering centers in Shanghai, proximate to those of VW and GM, the two largest car companies in China. But what this means is that as competition heats up, and the segmentation of the country into regional markets eases, there will be numbers of plants whose location will saddle them with high logistics costs coming and going. As long as the government mandates joint ventures, politics will trump sensible plant siting. The geography of China's industry makes no sense, and will cost firms money.

...GM's & VW's Chinese ventures appear to be quite profitable....

Then there's profitability. Perhaps some suppliers break China out as a separate geographic region, but I've yet to find any. (My understanding is that parts suppliers are not under the stricture of forming joint ventures, though likely many of them have because local partners add value.) Assemblers however are limited to joint ventures, and at the two market leaders (GM and VW) their profits are accounted on an equity basis, rather than as part of normal operating profits. Both however provide that number. It's likely to be an underestimate. The biggest potential divergence would be if these ventures paid dividends; that would reduce retained earnings and the rise in book value. That is, equity income falls, though it would be offset by dividend income. However, neither media reports nor financial statements provide any hint of such payments. Indeed, it's clear that at present all funds are being reinvested. Instead, the (post-tax) equity income is an overstatement because both venture partners have an incentive to use transfer pricing to the hilt, as they get 100% of any excess, but only half if they let the venture book a lower price and higher profits. On the Chinese side that includes the provision of real estate; for VW and GM it would include licensing fees for intellectual property. Both firms have relatively new facilities, and continue to invest at a prodigious pace; they likely have high offsets for depreciation. And of course GM and VW can only report half of total profits.

To the numbers: in the first 9 months of 2013 GM International Operations, under which China falls, realized equity income of $1.4 billion; total consolidated GM profits were $4.3 billion, so the Chinese joint ventures accounted for 32% of the total (and 32% of unit sales). Another way to view the China side is to compare profits in North America with profits in China. GMNA is 6% larger unit sales, and GM China lacks the gold mine of full-sized pickups. But given GM's 50% share, GM's joint ventures in China earned $2.8 billion while North America pulled in $2.2 billion. China makes money.

VW's numbers paint a similar picture. The increased equity valuation of VW's China operations came to €3.5 billion in the first 3 quarters of 2013; total profits were €8.8 billion. China thus accounted for 40% of the total, on 32% of global volume. Of course at present Europe weighs down VW's profits. Nevertheless given its 50% stake, its joint venture partners in China earned €7.0 billion. Its operations are older than those of GM, so it will have lower depreciation charges; its Santana plant in Shanghai, which contained used equipment, is likely fully amortized. Its Audi brand is also the dominant luxury vehicle in China. Still, at roughly US$9 billion it substantially out-earned GM. The bottom line again is that China makes money.

So perhaps we will move towards a bipolar world, in which North America and China come to dominate global automotive profits. As the industry is currently structured, though, China's geography will remain an impediment.

Thanks to David Wiest for discussing equity accounting with me.

FERRARI F40, TUDO QUE A FERRARI PERDEU

O maior de todos os Ferrari

Recentemente o programa britânico Top Gear mostrou uma matéria sobre o novíssimo Ferrari F12, uma maravilha tecnológica que literalmente voa pelas estradas.

O inolvidável Jeremy Clarkson mostrou detalhes interessantes e que fazem salivar os entusiastas das novidades. Magnífica é a cobertura que se abre no pára-choque dianteiro para aumentar a área de passagem de ar para os freios, comandada pela informação de sensores de temperatura, apenas um exemplo de alta tecnologia empregada no modelo. Há tanta coisa na máquina italiana que nem dá para lembrar. É necessário consultar ficha técnica e mais um descritivo do carro para entender o conteúdo. 

Mas Clarkson, após muito explorar a potência e agilidade do carro, disse que há dois problemas. Uma direção rápida e leve demais, que não dá tranquilidade ao motorista, e excesso de potência. Pela primeira vez na vida ele reclamou de excesso de potência. Foi realmente cômico escutar isso de Clarkson, e mais ainda os comentários de seus colegas de apresentação do viciante programa da BBC.

Como é possível um carro tão magnífico, feito por uma empresa com uma história tão significativa, conceber um produto que gere comentários negativos sobre dois dos sistemas que são dos mais importantes em carros de grande desempenho, direção e trem de força?

E eu, mais uma vez, me vi pensando no F40, meu Ferrari preferido.

Ùnico exemplar azul de fábrica

O F40 veio em uma era em que o mundo já estava ficando muito complicado, e ele mesmo tem ao menos um sistema bem sofisticado, que é sua injeção de combustível.

Mesmo assim, é um carro bem simples comparado ao conteúdo elétrico, hidráulico e eletrônico que se tem hoje em Ferraris e mesmo em muitos carros mais normais, ao ponto de ter apenas um item de conforto, o indispensável ar-condicionado. O carro todo é apenas funcional, sendo considerado mais um veículo de corrida do que de rua. Notando isso, chegamos à origem da marca, que seguramente é a mais conhecida do mundo no que se refere a carros, mais que a Ford com o modelo T, ou a Volkswagen com o Fusca.

CONTINUE LENDO >>>

Toyota as Number One

...remember Japan as Number One?...

I'm just back from a meeting of the Japan Foundation American Advisory Board, where part of the discussion was on the ups and downs of the field, such as high enrollments into the mid-1990s from those approaching the region in an instrumental way. Do you remember a prominent book of that era, Ezra Vogel's Japan as Number One. [mea culpa: he was the advisor for my undergraduate senior paper]

So what of Toyota as Number One? Is this a similar transitory phenomenon? – in many ways, yes. Despite all the doom-and-gloom reportage, though, Japan remains the 3rd largest economy [ahead of Germany, behind China and the US in absolute size] and overall a prosperous place. No, Japan never was going to take over the world. It remains important. Similarly, neither Toyota nor any other single firm will dominate the global auto industry, but Toyota is here to stay.

The metric that is in the headlines is total unit sales. That's not the only such metric; total revenue is another one. As an economist, I look to profits relative to assets. We could also look at quality measures, at the volume of top products (segment leadership), at "car of the year" and similar awards, and at positioning in growth markets. These give different answers – even if we can agree to an objective standard for how product in the industry's shifting array of joint ventures ought to be counted.

Total sales matters to Toyota in several ways. First, the impetus for this post, regaining the lead generates free (and favorable) publicity. After a period of supply disruptions (the 3/11 quake/tsunami followed by the floods in Thailand) and demand shocks (consequent to the US unintended acceleration incidents), this also is an important morale booster at Toyota and its dealers. Gloomy sales staff and gloomy sales go together, though which causes which may be ambiguous. In the US, what Toyota has done though is recover partway (14% of the market, down from 17% a few years back), while it's lower post-bankruptcy fixed costs allow GM to pursue profits rather than volume (18% of the market, rather than 21%). Only VW is picking up market share in North America.

In terms of total revenue, however, it is Volkswagen that has the lead by a hair. Yes, Toyota has Lexus and Hino, but VW has Audi and Porsche and its own truck division; VW has the Golf and other small cars; Toyota has its minicar subsidiary Daihatsu. GM is more focused on cars and light trucks. So in the 3 months ending September 30, 2012 VW had revenue of €48,848 million, Toyota had ¥5,406 billion and GM US$37,567 million. Using end-September 2012 exchange rates (US$1.00 = ¥78 = €0.78) gives revenue of $62.6 for VW and $69.3 for Toyota. At todays rates (US$1.00 = ¥90.5 = €0.74) the ranking shifts: $66 billion for VW and $60 billion for Toyota. So while Toyota may outsell GM and VW this year in unit terms, current exchange rates suggest VW is #1 in revenue. (GM is a distant #3.)

Then there's profits. Here the ranking is slightly different. VW earned a 4.2% return on €309 billion in assets; Toyota earned 0.9% on its ¥30 trillion in assets; GM earned 1.2% on its US$155 billion in assets. Here Toyota is third, not first. Now these companies are different in their structure; in particular, GM has only a very small finance unit, contributing only 7% to its profits. Similarly, VW gets about 11% of its profits from financial activities. It survives on vehicle sales. In contrast, 25% of Toyota's profits come from finance. So if we think of vehicles as the core of these firms, looking at the recent past we find Toyota trails in profitability.

How about quality? In the eyes of Consumer Reports and others, Toyota is no longer an automatic safe choice. Indeed, this past year they've recalled 4.5 million vehicles, more than their rivals. JDPowers ranks everyone very close to each other (look at the absolute numbers, not the rank order!). No one goes to the service bays of the big multibrand dealers but hearsay is that Toyota does not stand out from the standpoint of mechanics and warranty costs. (I don't know of any hard data.) That doesn't mean Toyota's vehicles aren't good; basically, everyone's vehicles are good, and compared to two decades ago, they're very good. No one is ahead in quality – thanks in part to Toyota's leadership in that area and the competitive pressure it exerted.

Similarly, in "xxx of the year" metrics Toyota is present but no single firm is dominant. Toyota doesn't appear in Ward's "best engines" list, while GM appears only once (Cadillac) and VW once (Audi). Honda, Ford and BMW lead their three regions. Another best car list – sorry, I deleted the email! – had a wide variety of makers as tops in specific segments; my recollection is that Toyota did well in minivans and entry luxury, but had no "winner" in regular cars. No one is outstanding in the sense of capturing a majority of "best" ratings.

Now going forward Toyota's profitability has headwinds and tailwinds. It continues to suffer from the political tensions between Japan and China that affect its sales in the latter market, where VW and particularly GM continue to forge ahead. Its domestic market is weak; as the number of licensed drivers falls, firms producing inside Japan will struggle to match capacity with sales.

In contrast, at an exchange rate of ¥90/$1.00 exports will be much more attractive. In particular, most of Toyota's Lexus brand are exported from Japan, so even without better volume, revenue and profits will rebound. They won't make money in Europe, but GM will lose a small fortune. So far VW seems to have come through well amidst the Euro crisis, but we'll see whether that persists. My hunch is that VW will remain at the top of the global Big Three in profitability, while Toyota will pull ahead of GM. But in terms of sheer volume, over the next few years growth in China and Brazil will benefit GM and VW relative to Toyota, while the US market is unlikely to improve much for anyone. So the #1 sales slot will shift back and forth.

...mike smitka...

The Industry in the face of the Euro's (partial) demise

...Eurxit and beyond...

The Euro as currently configured is not sustainable, from both an economic and from a political perspective. Spain cannot possibly deflate its way back to balance, and 20% overall unemployment and 50% youth unemployment is not politically tolerable. The only way out – forcing German banks to write off their Spanish debt now, matched by stimulus sufficient to turn Germany into a net importer – is not on the policy horizon, though in due course German banks will in fact have to write down debt.

If Spain falls, so will other parts of the Euro zone. Greece of course, and Portugal, and Ireland but not Italy? – I'm not euro-centric and don't know enough to create my own list. I assume France, Spain, Benelux, Austria and Finland will remain. To highlight issues, however, it is sufficient to focus on Spain.

The Euro exit process – I've seen the term "Grexit" used for the likely initial case – is not clear-cut. I would hope that central bankers and pan-European financial institutions are (quietly) working on possible scenarios. If so, in our leak-prone world, they really have been quiet. At the moment, a sensible assumption might be a three years of chaos in those exiting, since there seems to be no planning to support a quick and clean break (cf. the 1997 Asian Financial Crisis). In the interim, those remaining on the Euro would face a corresponding period of deep recession. Then would come two years of recovery that would leave economies below peak, followed by an era of more gradual reconstruction. The total: five lean years, less than what drove Israel to Egypt, but potentially just as devastating to the European heartland.

Not all auto firms are equal. For several – Fiat, Peugeot and Renault – Europe dominates their operations. So far VW appears exceptional, because its German sales base has escaped the current crisis and it is larger outside Europe. Then there are BMW and Mercedes, in the upper segment of the market, about which I know little, and so will hazard no guesses.

Other firms have a footprint in Europe, but are not dominated by what happens there: Fordwerke and Opel are but one part of the global operations of Ford and GM. Europe is peripheral for Toyota, Nissan, Honda and Hyundai. Their parent companies may or may not decide to tough things out – GM will have the hardest time –but unlike Euro-centric firms they have the option of exiting. That would matter if both Ford and Opel/GM leave the market, but otherwise would not remove enough capacity to change the equation.

Then there are automotive suppliers, the larger of which have substantial bases in the Americas and Asia, but still have their core in the Euro zone. My sense from visiting suppliers on a regular basis is that they've done a good job of geographic rebalance, to the benefit of firms headquartered in Europe and the detriment of those headquartered in the US. Asian suppliers are on average relatively weaker in Europe, and so will be less affected. Catastrophic failure of any of the large European suppliers would be catastrophic to the industry, the equivalent of Lehman Brothers in the financial world. Renault would (quietly) cheer the failure of PSA or Opel. All would lose in a meltdown of the supplier base.

Shifting gears from firms to geography, Eurxit (pardon the neologism) would bring a large devaluation to Spain. That is most obvious relative to the Euro; imports from Germany and France [Grance? Framany? – the new Europe will need new jargon] would be much more expensive. However, I would also expect the (new) peso to depreciate relative to currencies in peripheral Europe, since Hungary, the UK, Russia and Turkey already reflect a more sustainable level relative to the Euro.

If it could avoid collapse during the transition, Seat as a local firm (albeit also a VW subsidiary) would benefit from a large shift in relative prices that would improve its strategic position. It could become a true value brand in Europe, with increased exports and (due to the higher cost of imports) would have a near-unassailable position in its home market. Seat might still be Skoda's poorer brother, but its place in the VW family would be more secure. Now the labor cost component of local [Spanish] assembly is modest, and many parts and components are imported, muting the initial benefit. Over the space of a few years, however, local content would rise and with it the peso component of the cost base.

In contrast, firms remaining in the Euro cost base would see their export markets shrink, and the burden of the zone's excess capacity is already heavy. Who has deep pockets? VW, yes, but (potentially) Ford, Opel, Toyota, Nissan, Honda and Hyundai. Chrysler isn't big enough to fully balance Fiat, nor Nissan to balance Renault. Absent government intervention, it is hard to imagine all of these small firms surviving five lean years. In addition, GM's pockets aren't deep; Ford is still rebuilding its balance sheet. Eurxit won't help the US economy and it won't help China, so won't help either firm. So it is conceivable that one of them would exit. It is almost inevitable that the European market would witness multiple bailouts, given a greater political sensitivity to unemployment than in the US. This would be to the detriment of VW, and to any of the branch operations of US and Asian-based firms that remain.

This is my first pass at the implications of Eurxit. Additional differentiation would come from breaking down market shares of individual firms between Eurxit and Euro countries; who is strong in the Mediterranean periphery, and hence more vulnerable? Who has the weakest balance sheet among OEMs and among suppliers? On which side of the divide will Italy lie? Who has a stronger base in the non-euro periphery (Turkey, Hungary, Poland, Russia) and so may be better positioned to pick up pieces of the market via exports?

We can always hope for a miracle European unity, that France and Germany can act as one. So far the fear factor is failing to force fraternity. The initial Eurxit – Grexit? – may change that, but my hunch is that by the time it will be too late.

Finally, this places a fundamental strategic choice in front of firms not irrevocably committed to Europe: do you marshal resources for a long and expensive slog there, or do you prepare to retreat and instead concentrate on the Western Hemisphere and Asia? Even with a reconfigured "euro" divide Europe will remain on average prosperous, and with a population larger than the US will remain potentially profitable. But is every current participant willing to wait until 2018 to realize that potential?

...Mike Smitka...