Opel & GM

Mike Smitka
Further to my earlier post, Is there a GM without Opel?, the sticking points of GM's negotiations with the Magna-Gaz/Sberbank are over intellectual property rights: Opels are (currently) the core of GM's international operations and rights thereto can't be freely given away. My opinion stands: GM cannot afford to let Opel go and remain an ongoing enterprise. Too many of its engineering resources are bundled into Opel, and vice-versa. Germany doesn't want restructuring, enough unemployment already, and as partners in the current "trust" that controls Opel... How this works out is crucial. And apparently some at GM concur.
More posts shortly, following up on the June Business History Conference in Milan, on the tension between "administration" (as in MBA) and management (as in long-run health) and on health care. But first I have a book review, a manuscript review and an article to complete, all on the Japanese economy. And it's hard not to spend time reading about political turmoil, with PM Aso about to dissolve the Diet for an election that will almost surely dislodge him (and probably the ruling LDP coalition) from power.

Toyota and General Motors

Mike Smitka
The new General Motors was spun out of bankruptcy on Friday, July 10th. Its prospects are uncertain. The new cost structure and (one hopes) an end to complacency should lead in time to successful enterprise. Eventually: we should find caution in that GM's now much larger rival Toyota continues not only to lose money, but to lose it at a faster rate than GM-old.
What gives?
First, Toyota has gone where the money is: larger vehicles in North America. Toyota now sports V-8 engines, a full-sized pickup truck and a range of SUVs and other light trucks. Does that sound familiar? Well, so are the consequences: red ink. It was making its Tundra pickup in both Indiana and Texas; no more. All production is now in Texas – and that plant was closed for over 3 months in summer-fall 2008, and runs only one instead of two shifts. So it has billions in sunk costs that are generating little to no revenue, and is reluctant to lay off workers, as that policy has been a mainstay in its battle to keep plants union-free. Nor is the prognosis good: even if gasoline prices stay low, Toyota has few rural dealerships. Despite cutbacks, the Detroit Three still do.
Second, Toyota has focused on the American market in general, again because that is where the money is. The company is a modest player in Europe, and a latecomer to China; the population in Japan is aging, and the number of licensed drivers in its home market is in decline. It may book profits in Japan, because that's where the production of most Lexus vehicles is still located. But sales depend on the US.
It gets worse: product planning also followed the money. Anyone of my generation can remember (or often owned) a Toyota at one time (my first new car purchase, in 1981, was a Toyota Tercel). They were small, sparingly powered rust-buckets, but with good mechanicals for their time (by today's standards, they were junk). No longer are Toyotas small or sparingly powered. That pairing generates profits – the public perception of fuel economy is swayed by the Prius, but the Prius makes no money, at least since the price was lowered to fight the Honda Insight at the same time that the yen strengthened. But back to that pairing: such vehicles are peculiar to the North American market, and don't sell well in Japan or Europe. Those markets are left with larger vehicles that don't fit, they're just a bit too large on every dimension. Toyota thus struggles to sell such potential high-margin vehicles everywhere else in the world.
Third, they became a big company with big ambitions, replete with MBAs in various HQ functions. For those who don't know their history, Toyota was bailed out by the Japanese government in 1950, because they kept "pushing the metal" on dealers despite a recession. One measure, along with kicking the Toyota family out of management, was to split off the sales functions to increase their ability to say "no" to the factory. The separation between Toyota Auto Sales and Toyota Motors lasted about 30 years, but they've now been merged for 25 years. Headquarters staff over the past decade came to dominate product planning, investment planning, well, MBAs plan. But not always well, not when they are far removed from the "real" world of sales and manufacturing. Sure, Toyota was earning a better return on equity, 5+% instead of the early 3-4%, while return on equity was pushed to 15% and above. And sales kept increasing, first overtaking VW, and then briefly GM.
They were going to rule the world; they had already taken over Daihatsu and Hino inside Japan, and more recently acquired stakes in Fuji Heavy Industries ("Subaru") and Isuzu, both former GM affiliates. They upped their share of Denso to a controlling stake. And there was Lexus, and the Tundra, all those other nice high-margin vehicles. To support this growing empire took a lot of investment. But while the product plan looked good on paper, it wasn't necessarily what the people on the ground were comfortable making and selling. Furthermore, product proliferated, a car for every niche for every name plate. Inside Japan Toyota maintained 5 distribution channels and 47 cars in its 4 "legacy" channels, 9 for its new Lexus channel, and 13 more at Daihatsu (covering the minicar end of the spectrum). Add another 14 light commercial vehicles – but leaving out all of the heavy truck and bus makes of Hino – and they have 83 model names inside their domestic market. [my count] Toyota's brands are muddied and the cars are bland.
It doesn't take much imagination to see what happens to marketing costs. To make matters worse, Toyota outright owns several large (40-plus sales point) urban dealerships, because they can't operate as profitable ventures. (Not that people seconded from headquarters – with salaries paid by the parent company – improve matters.) And think of the engineers: they're so busy doing product, and all that totally new stuff for the US, that they don't have time to do things right, at least by their standards. Recalls are up sharply. Costs, too, because forcing commonality takes time, and time they do not have. (Remember, in today's auto industry most manufacturing is at parts firms, so using parts in common is the key to cost control.)
Fourth, they have their own unions to contend with, and those unions include engineers and regular office workers, not just factory hands. Plus it's easier to coordinate inside Japan, because even today language skills are weak. So we now find Toyota entering a steep recession with the ability to build 10 million vehicles, all according to plans from HQ, but with sales of only 6.5 million. Worse, they have added to that capacity not only in places such as Texas but also in Japan, where they can now build 4.5 million vehicles. In the process they have allowed their export share to gradually rise from under 40% in the mid-1990s to roughly 65% in 2008. But egven as exports have fallen due to the global recession the yen has strengthened, amplifying their losses.
We may not have seen the worst of it. Toyota has quietly added a couple stamping facilities, bought from a failing domestic supplier. But it surely has many other suppliers, pushed to match its expansion, that have weaker cash reserves and weaker management. As things stand, they will have to pick up the tab (which to me is ethically appropriate, but is surely not part of the financial projections of their MBAs). And already their ROA has swung from 5.9% in April-June 2007 to -10.4% in Jan-Mar 2009. That's a swing in profits before taxes of Δ¥1,654 billion (or ΔUS$17.8 billion at this weeks average of ¥93 per dollar). Toyota maintains a sterling (though recently lowered) credit rating and sits on $30 billion in cash and securities and $40 billion in financial receivables. But it also has $64 billion in short-term debt and long-term debt due this fiscal year. Far better than GM, but as a big, heavy firm its cushion is not as comfortable as it once was.
Wish the new president Toyoda Akio good luck! If it wasn't for his ability to borrow to tide things over, he'd be facing a tougher battle than GM's new CEO Fritz Henderson.

This article relies on Toyota financial reports, on a 3-part series in the Daily Automotive News 小室祥子「トヨタ・新時代への展望」『日刊自動車新聞』 連載: 26, 27, 30 June 2009 and an article in Bungei Shunju 井上久男「覇者トヨタに何が起きたのか」『文芸春秋』March 2009, 94−108. While I did not stumble across it before drafting this note, see also the 22 June 2009 Bloomberg article Toyoda Asks How Many Times Toyota Errs Emulating GM Failures by John Lippert, Alan Ohnsman and Kae Inoue. Based on it, I edited my comments on the operation of the San Antonio, TX truck plant. They also note that Toyota dedicated its Woodstock, Ontario car plant in December 2008, and provide other examples of the firm's (overly) ambitious expansion plans.

In Defense of Dealers

A few years back Michael Dell was quoted as saying he thought the auto industry should adopt elements of his “build to order” PC business model. He predicted that consumers would someday purchase new vehicles directly from the Manufacturer. Obviously, he didn’t put much value on what the Dealer adds to the Consumer / Manufacturer equation. But after making a pass at Asbury Group Mr. Dell is now a Dealer himself, having partnered with a former head of Sonic to buy dealerships. While we haven’t heard much about that venture recently, we do recall Mr. Dell’s comments about Dealers being an unnecessary and expensive link in the distribution chain. Not long after, Mr. J. D. Power made a similarly negative comment in an interview with the Wall Street Journal and was greeted with tremendous blowback. He was rumored to be a pariah at his company’s own hospitality suite at that year’s National Auto Dealer Association convention. It was not long thereafter J. D. Power and Associates came to be owned by the McGraw Hill Companies.
It seems it has become common for self appointed experts to lecture the industry on how to best retail and service new vehicles. We recall Ford Motor Company’s ill-fated attempt at being a Retailer. Ford purchased all the Ford Dealerships in a number of markets, including Tulsa and Oklahoma City. This experiment took place under the Jacque Nassar regime and provided additional evidence that manufacturers probably don’t know how to retail new vehicles profitably. Ford couldn’t make the venture work even as they owned all the Ford stores in the market! The Ford Auto Collection experiment, and the Saturn experiment at GM, didn’t burnish the concept of “One Price Selling” either. After their short and costly experiment, Ford decided it was better to sell their Dealerships back to genuine Retailers.
People outside the business typically think the secret to success in auto sales is to keep cutting the price and make it up in volume. Real Dealers know they have to make gross profit wherever they can. During their time as Dealers, Ford focused on selling new vehicles. After all, Ford is a Manufacturer. A Dealer knows that selling new vehicles is likely to be a losing proposition at times, especially Detroit 3 Dealers.
They structure their business accordingly. For that reason they learn to make up profit in their other departments. This allows them to sell new vehicles at a net loss when necessary, but still maintain overall profitability. Ford thought they could increase volume with “One Price” and regarded the pre-owned business as a necessary evil. The result? They actually achieved lower new vehicle sales at lower gross profits than before, and gave their pre-owned business away. It’s no wonder they didn’t make money!
Now the “authorities” in charge of the economy assert that GM and Chrysler would be better off with fewer Dealers, as if Dealers add significantly to a Manufacturer’s costs. This is not to say there hasn’t been significant “over-dealering”, especially in metro markets. But “over-dealering” impacts Dealer’s profitability, not the Manufacturer’s.

The Other Side
Let’s look at it from a Dealer’s perspective. Dealers these days have typically been pressured by their Manufacturers into ever more expensive and expansive facilities, despite the fact that a consumer’s Internet screen is now their “showroom” of choice. More and more consumers go to the “brick and mortar” Dealership to view inventory, acquire information, take a test drive, and perhaps get a price quote. The consumer then goes back to their PC to obtain price quotes on their desired vehicle. A Dealer’s conventional sales staff is often competing against its own Internet department, as well as other Dealers, when it comes to price! Moreover, new vehicles are pretty much a commodity these days. An excellent book on the subject is Dale Pollak’s Velocity. He points out that the new vehicle business has been an “efficient market” for years. To economists, an “efficient market” is one where both buyers and sellers have equal information and neither has any significant advantage. According to Wikipedia, “The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.” In other words, there is significant downward pressure on Dealers’ new vehicle gross profits and they are often a loss leader. Velocity is primarily about the pre-owned market, but the principles of market efficiency have applied to new vehicles even longer than to pre-owned.
The current discussion in Washington includes forcing GM and Chrysler to shed Dealers as a condition of receiving “tax payer backed” loans. For some reason, some members of Congress think getting rid of Dealers will save money for GM and Chrysler. They obviously don’t know that once established, there is very little, if any, cost to the Manufacturers for their Dealer networks. As a matter of fact, Dealers are the Manufacturer’s customers, not the buying public. The buying public is the customer of Dealers! Is it logical to try to increase sales by reducing customers?
In addition to selling new vehicles and parts to their Dealers, the Manufacturers also sell them special tools, equipment, furniture and numerous other expensive programs. The Manufacturers have transferred immense costs and risk to their Dealers. The risk of real estate, receivables, inventory and inventory financing is all born by Dealers, not by Manufacturers. In fact, a recent study commissioned by NADA stated, “Far from being a burden to the Manufacturer it represents, the Automobile Dealer supports the Manufacturer’s efforts by providing a vast distribution channel that allows for efficient flow of the Manufacturer’s product to the public at virtually no cost to the Manufacturer. The independently owned and independently financed franchised Automobile Dealer network is a critical asset to the Auto Manufacturers. U.S. Auto Dealers have $233.5 billion invested in their businesses. This capital is supplied by 20,700 independent dealerships that employ and train over 1.1 million people.” According to Dr. Michael Smitka, Professor of Economics at Washington and Lee University and an auto industry expert, “Dealer profitability based on their $233 billion dollar investment and a reasonable 8% return should equate to an 18 billion dollar return for Dealers in aggregate. We’ve seen no evidence that target has been met over the years.”
Further, Dealers provide the resources to stock inventory. They take trade-ins. They arrange financing. They collect and pay billions of dollars per year in taxes. Combined, they represent 20% of all retail sales in the U.S. Unknown to the general public, Dealers collectively have more money invested in their business than their Manufacturers have invested in theirs! Someone needs to explain to me how a Manufacturer can morally and/or legally push major investment and risk on their Dealers/Franchisees and then arbitrarily stop supplying them with product, outside of bankruptcy.
GM killed Oldsmobile by first starving it for product. What was once GM’s most profitable division received “me too,” “badge engineered” vehicles to sell, at a higher price than the same vehicle from other GM divisions. At the same time they backed these less than wonderful vehicles with a marketing campaign that stated, “It’s Not Your Father’s Oldsmobile.” This only further alienated their already aging customer base but failed to turn on younger buyers to their “me too” vehicles.
The money that should have been invested to bolster Oldsmobile was spent on a revolutionary new idea named Saturn. Saturn NEVER made money and Oldsmobile died a slow death. But at least Oldsmobile Dealers received a measure of compensation from GM. It is reported to have cost GM over a billion dollars to shed Oldsmobile, in yesterday’s dollars.

The Upside to Saturn
The best thing to come out of Roger Smith’s Saturn experiment is the Saturn Dealer network and their franchise agreement. This franchise agreement is unique in the U.S, but common in other some other countries, including Japan. It grants distribution rights for an area or region, rather than an individual market. GM has refused to allow Saturn Dealers to dual with other makes. A Dealer friend once said, “When you can’t pay the rent, you have to take in boarders!” But GM has denied this option to Saturn dealers despite the fact they haven’t provided vehicles to Saturn Dealers that the market wants in enough volume to allow its Dealers to be viable. From the beginning they were provided a line of mostly “tepid” vehicles to sell. While the recent Aura and Sky are great vehicles they haven’t been enough to save Saturn!
Besides, the Detroit 3 have never been able to consistently make money selling small vehicles. Consumers had some renewed interest in Saturn’s offerings when fuel prices spiked but that quickly waned. Imagine the result if the Detroit 3 were to design and build only smaller fuel efficient vehicles, as mandated by Congress, and the price of fuel stays low.
Nevertheless, Saturn Dealers are a resourceful bunch and have learned to survive by being excellent operators, focusing on the pre-owned and service ends of the business. They “kill their customers with kindness!” Now they have officially been notified that they will be starved for new products and will soon be phased out. Let’s hope their innovative franchise setup and professional Dealer body attracts a buyer that gives them the opportunity to represent a line of compelling vehicles, whether they be from China, India, Italy, or wherever. I wonder what might happen if Fiat decides they are better off buying Saturn instead of partnering with Chrysler? Saturn Dealers all have substantial investments in facilities that have little value if a successful automotive franchise isn’t operating in them.

Beyond Suburbia
We should also have a special appreciation for “country” Dealers. These Dealers are also resourceful and have learned how to make money in the pre-owned and service business. This has been out of necessity as they typically have not had access to any real quantity of their Manufacturer’s “hot merchandise” when their OEM produced a “winner.” Many have become dependent on their Manufacturer’s Certified Pre-Owned (CPO) offerings. Without a franchise that allows them to buy CPO caliber “program vehicles,” their futures are in doubt.
What does an Auto Dealer do for a community? Aside from local employment, local service, safety recalls, warranty repairs, local charitable work, etc., Dealers collect Sales Tax! A portion of that Sales Tax goes to local government. If a Dealer goes out of business in a community and vehicle buyers are forced to drive out of the locale to make their purchase, the local tax revenue stays where the vehicle is purchased, depriving the previous municipality of its tax revenue. This is a major issue! There are many circumstances where local government has provided financing and other support to maintain a local Dealer and its associated tax base. Imagine a municipality guaranteeing a loan for a local Dealer and the Dealer’s Manufacturer arbitrarily cancels or terminates the franchise agreement or stops supplying product. In this case the Manufacturer probably forced the Dealer to make substantial investments before shutting off product. I can hear the attorneys licking their chops.

What’s Next for the GM & Chrysler?
GM and Chrysler are between a rock and a hard place! They are afraid of Chapter 11 (re-organizational) bankruptcy. They feel few consumers will buy a vehicle from a bankrupt Manufacturer with no real assurance of warranty or resale value. If they don’t go Chapter 11, they are obligated to honor their contractual agreements, including their franchise agreements.

On a macro level, a Manufacturer bankruptcy would drop billions of dollars of pension and health care obligations on the federal government. The United Airlines bankruptcy dropped 6.6 billion dollars on the Pension Benefit Guaranty Corporation! (read that Federal Government.) Imagine GM, Chrysler, and a slew of suppliers hitting that system at the same time. The PBGC was already 23 billion dollars in deficit BEFORE the record UAL bankruptcy. It’s no wonder the government is proving fairly easy to work with for two of the Detroit 3.

On the Bright Side
Fortunately Auto Dealers do have some “aces in the hole!” They have protection from state AND federal laws protecting Dealers and/or Franchisees from their suppliers. These laws are based on “fairness” and cannot be merely swept away by mandate from Congress, a Car Czar, or a committee. Auto Dealers have effective lobbying groups in the form of their state trade associations, Political Action Committees, and most importantly the National Auto Dealer Association. Dealers are victims of many of the circumstances that led to the demise of their Manufacturers, but Dealers had nothing to do with the melt down of the U.S. financial system that dramatically impacted them. They had nothing to do with the sudden spike in fuel prices that rendered much of their inventory “sale proof” and decimated the value of their used vehicle inventories.
Dealers don’t dictate to their Manufacturers what to design and build. Many are currently victimized by Manufacturer sales incentive programs that require the Dealer to order additional vehicles for inventory as a price of admission to the program. These programs may serve the Manufacturer’s purpose but are catastrophic to a Dealer who is sitting on a 150 days (or greater) supply of inventory.
At the same time, the same Dealer is probably facing the prospect of having to “curtail” floor planned vehicles as a result of frequently arbitrary and frivolous mandates from lenders - often the Manufacturer’s captive. This comes at a time when working capital is a most precious commodity. This practice often puts the dealer in the position of having to decline program participation and face the market with a serious cost penalty versus other Dealers selling the same brand. Many of these Dealers are already on “finance hold” due to too much inventory and/or deterioration of their balance sheet. So now they face having a serious cost penalty in selling the inventory they purchased in good faith from their Manufacturer months ago.
Many Manufacturer programs are frequently designed to give the OEM a “free float” on the Dealer’s working capital while at the same time demanding immediate payment from the Dealer for the monthly parts statement.
In summary, Dealers are not only important, but absolutely necessary to a Manufacturer’s survival and ongoing success. Shutting down an entire division may make economic sense to a Manufacturer, if they cannot afford to design and build vehicles to supply that Division’s Dealers. But it will be quite expensive to do so. Merely thinning out Dealers as a method of increasing Manufacturer profitability is a totally flawed concept and strategies designed to force Dealers out of business should be dealt with sternly.

A reprint of the Ruggles Report February 2009