Auto Bailout Redux: Warren Buffett

...it was Bush who bailed out GM -- Obama forced it into bankruptcy...

Steve Rattner's blog points out a February 27th CNBS interview with Warren Buffet that affirms what David Ruggles and I have argued from the start on our Autos and Economics blog, and reiterated here: that the alternative to the government provision of DIP financing for an orderly Chapter 11 restructuring of GM and Chrysler (as though bankruptcy is a bailout!) was a catastrophic dissolution via Chapter 7 ("close your doors forever" bankruptcy). As Buffett notes, capital markets weren't functioning, and there were no sources of working capital for firms seeking Chapter 11. Indeed, he himself told one of those firms "no" -- and unlike banks, he was not constrained by liquidity concerns and depleted capital. Rather, everyone was hunkered down, and clearly uninterested in what a priori was a very risky venture.

Now it's not as though the reorganization was perfect; lots of dealers had their franchises yanked, which neither lowered operating costs at GM nor improved their sales. That seems to have resulted from the input of a consultant who had worked for NADA (the National Auto Dealers Association). Of course every dealer wishes for one less competitor, but that's a tension with every franchise system: what's good for the franchisor is not always good for the franchisee. With hindsight there might have been wiggle room on other terms and conditions. But it's hard to fault what was done from a real-time perspective. Indeed, the speed with which the Chapter 11 restructuring was consummated should give creditors in other bankruptcies, who often shell out staggering legal fees for years on end, food for thought. And speed was critical to the revival of GM and Chrysler, and for keeping suppliers and the rest of the domestic auto industry afloat.

Let me close with a personal reflection. We will continue to quibble over the appropriate role of government in our society. We will always find fault, too, because by and large government is engaged in providing services that can't be quantified or for which market prices aren't available -- economists and environmental scientists can construct models to delimit how much less pollution is worth, but that's a far cry from trying to figure out how much a gallon of milk is worth.

Overall, however, I've always been impressed with the service orientation of those in the public sector, from local school teachers (the biggest component of Leviathan, and certainly not in it for the money!) to individuals such as Mr. Rattner (who incurred a pile of legal bills for the privilege of serving). Kudos! -- our society would be poorer without them

Mike Smitka
An essentially identical post is at the US and Economics blog.
My apologies if this shows up at an odd time; I may have forgotten to hit "publish" after writing it, or else went back to edit it without realizing I had to re-publish it.

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

Downsizing

While interrupted from time to time by the business cycle – exceptionally so at the moment – automotive demand has expanded steadily since the end of WWII in the US, Japan and the EU. As a consequence the normal challenge for auto companies has been expansion. That process was not always orderly, as the different divisions of the larger firms fought for product for their dealers. Such product overlap is particularly severe at Toyota and GM, with the most sales channels. For dealers there is modest downside; additional models mean additional inventory. But each dealer hopes to pick up some incremental sales. Unfortunately that includes sales cannibalized from other sales channels – Pontiac sales robbing from those of Chevrolet – and so the benefits to the manufacturer are smaller. Overall however the bias (as in most franchising systems) is to have too many sales points and too many products from the standpoint of the system as a whole. As disorderly as the expansion path may appear, with firms responding to "hits" by their rivals with product that may mesh poorly with the overall vehicle lineup, reversing that process is much more difficult. Doing it in an orderly manner is well-nigh impossible.

Financial implications aside, trimming capacity presents formidable strategic challenges. First, the menu of vehicle programs must be developed with a 6-8 year time horizon. The allocation of engineering resources is a complicated dance, and has to also mesh with assembly capacity. A firm can work on only 1-2 vehicles in a size class at a time, and delaying a program until later then means some future program must be moved forward or otherwise shifted. So the dance has to position the players with a vision of where the firm wants to be 8 years down the road. That is hard enough when most vehicles programs are merely (?!) developing a replacement to existing product. Downsizing will almost inevitably mean that a firm is set to develop the wrong vehicles in the wrong order.

Second, if products are located rationally in consumer space, canceling one model creates a hole in the overall product lineup. That means that there are greater benefits from moving adjacent vehicles to the head of the development queue. So one less model increases the pressure to re-engineer two or more adjacent vehicles. Doing that of course costs money rather than saves money, so a hole must remain. Such a hole affects dealerships; if a particular sales channel is starved for product, then it will be more difficult for the dealers to maintain the presence in the market in overall staffing and advertising needed to support vehicles that ought to sell well. Downsizing, in other words, can amplify an initial decline in sales. And that's without taking into consideration any negative publicity from media coverage of the process.

Third, developing vehicles entails teamwork; downsizing means breaking up teams. Trying to "cherry pick" the good engineers is hard, and hurts morale – and of course a team without spirit is not much of a team, as is a team that has never played together before, even if (especially if?) it is composed of all-stars. Voluntary buyouts may force a company to "buy back" workers if too many in a give area quit. And in either case a firm will find it difficult to continue recruiting young engineers and other functions where learning the trade takes time.

Fourth, uncertainty looms large. CAFE (fuel efficiency) mandates skew incentives for where to allocate resources, with an impact that varies from firm to firm depending on their mix of domestic and imported vehicles. "Green" incentives that accrue to vehicles that may in fact not be very efficient, the lack of an energy policy that creates uncertainty in the path of energy prices (and which in the US makes diesel more expensive rather than cheaper than gasoline), and the presence of state and local economic development incentives that make a new plant for a company with an expanding market share cheaper than an old plant for a firm with a declining share all make life more complicated.

Then there are legacy costs. Incumbents in the US already had large number of retirees, due to the cumulate impact of increases in longevity and increases in productivity, that left them with an unfavorable ratio of retirees to workers. Downsizing makes things worse. New entrants have no such problems. They have virtually no retirees, their healthcare costs are further lowered by the relatively young age of their workforce, and they have "modern" benefit plans rife with deductibles and co-pays, things that were of little or no concern when such benefits were negotiated by the incumbents in the 1950s.

Finally, what scale is needed for survival? Electric vehicles, hybrid diesels, hybrid gasoline vehicles, natural gas vehicles, fuel cell vehicles – it is unclear which of the next generation of propulsion plants will prove fruitful. All require significant expenditures now that will not generate revenue in the near term. A large firm can have multiple platform teams, very small cars in Korea, small cars in Germany, midsized-cars and light trucks in the US, real-wheel drive projects in Australia, and so on. There are potentially large benefits from that, though to date the track record of "world" cars is poor, in part because regulatory barriers and variations in manufacturing infrastructure make it expensive and time-consuming to adapt a European car for the US market.

Of course there is excess capacity in the market alongside too many models. The ease of entry means that will not change in the medium term – remember, there are 14 producers in NAFTA, not to mention importers. Dealers face their own problems, particularly for those in urban areas, as the internet undermines the value of a large, expensive physical footprint. Downsizing individual firms affects suppliers in an uneven manner, but few suppliers depend on a single customer. Viewed from the other end, a Toyota or a Honda is reliant on the health of suppliers for whom one or another Detroit firm is a major customer.

In short, downsizing can unravel along multiple dimensions. And probably will.

Back to the Beginnings

Well, today came the first steps towards the de facto reorganization of GM without going through the de jure process of bankruptcy court. The game has switched from softball to hardball ... squash. No more finesse, whoever has the most power wins. It's not GM's bondholders and it's not the UAW. But it may be the collapsing economy that proves the most powerful, not the Obama administration.

Arguing that issue will take time -- my outline is 5 single-spaced pages, not the sort of thing for which a blog is suited. Instead let's do a little applied IO (industrial organization), beginning about a century back. The auto industry evolved in a manner familiar from that perspective, at least in its stages if not the overall process.

After the formative years of playing with multiple technical standards and marketing strategies, as well as corporate structures, Henry Ford latched onto a combination that worked. He assembled parts and sold his Model T to dealers, collecting money up front, and paid suppliers in arrears. Vanadium steel alloys and ultimately the moving assembly line enabled him to push down the weight of his car, and up the speed of assembly. Inventory turns, all that -- though since the old man hated accountants, there are no books to trace the financial evolution of the firm. In any case, he soon dominated the market, in the US, in Europe, in Asia.

Now Henry owned the firm, or at least he did after forcing out the other shareholders, something he'd done twice before in the forerunners to the Ford Motor Company. (He was not a nice man.) No one could dissuade him from his policy of ever-lower prices as he improved the basic model and (for many years running) lowered his costs. But there was a bottom to how low he could push costs, and others began attacking his position from upmarket. GM succeeded, and the Model T began a gradual decline, until in 1926 Ford was forced to pull it from the market while he rushed the development of the Model A. By the time he launched it in 1927, Chrysler had also emerged as a player. Monopoly power made Henry insensitive to the shifting market, and the lack of outside shareholders meant there was no restraint on his whims. Ford was free to give away market share; if he wanted to bankrupt his firm, that was his business.

Fast forward 50 years for a variation on that story, to which I will provide another spin. From the early 1950s into the early 1970s GM was the dominant firm in the US auto industry (and with the exception of Japan, number one or two in the markets that mattered outside the US). For twenty years running it was the most profitable manufacturer (and often the most profitable firm) in the world, earning a 20% return on assets. But with just over 50% of the US market, antitrust considerations constrained additional expansion; it had to allow Ford and Chrysler a share of the market. Through price leadership it could nevertheless coordinate pricing policy with them; its economies of scale were considerable, and it was the low cost producer. The other two firms thus wanted to avoid a price war; though they could set prices below GM's umbrella, they could not be unduly aggressive.

Eventually such high profits did encourage new entry. Via imports the Scandinavians had a modest presence, as for a while did British, Italian and French firms. Of course there was also American Motors, an amalgam of US firms that emerged -- or rather merged -- after WWII. More successful was the German firm VW, particularly when a fad for small cars swept the US in the late 1960s, making the Beetle a hit. But as had happened in the late 1950s, the small car fad passed and the market for that low-profit segment shrank. Detroit was relieved, because if they all entered, it would have been a bloodbath: flooding the market with low-margin products was not an attractive business proposition. When there was another swing towards small cars in the late 1970s, following the first and especially the second oil crisis, VW stumbled and it was Japanese firms that captured the small car market. Again, the Detroit Three wisely sat on the sidelines. But US government policy worked against GM and the others. Ronald Reagan's VER ["voluntary" export restraint] policy effectively asked the Japanese government to organize a cartel to raise prices in the US. Carter's CAFE [corporate average fuel economy] standard and the earlier Clean Air Act bolstered the position of these new entrants, because they favored small cars and imports. The profits of the VER and the breathing space of other policies gave the Japanese time to build a distribution network and to move upmarket. We know the rest of the story.

Back to substance: over the next quarter century GM steadily ceded market share to these and other entrants. (At present 14 firms assemble vehicles inside NAFTA -- ignoring equity ties, two are Korean, three German, three are Detroit-based, and six are Japanese.) Doing so was rational. GM could have lowered profits to preserve share. But why should it do so when it was so dominant? The modest increment garnered by the new entrants was no more than a burr on its side, and shareholders would rightly have screamed if it gave up its bounteous profits that it earned on its 50% share of the market in an effort to scare off these entrants. Henry Ford was irrational in his strategy. But GM was rational in its refusal to fight. Making way for fringe firms to enter the market is the only sensible strategy for a dominant firm.

Eventually a dominant firm thus will cease to be dominant. So it was with GM, though it hung onto the most profitable segment, light trucks, and did well thereby. That would be the end of the story if downsizing was easy in the auto industry. Even then it might not have mattered had GM not had to shoulder pensions and especially healthcare obligations for its increasing numbers of retirees. Such aspects must await another post.

Let me reiterate the central point. GM's management certainly made many mistakes. This included such bone-headed investments as Saturn, billions spent on automation and other hoped-for "magic bullets" that ignored basic operational competence, and an overarching role for people with a background in finance rather than manufacturing, engineering or marketing. Nevertheless its core strategy was consistent with earning high levels of profits for its shareholders. Indeed, it was sufficiently successful in this that going into the current recession it was Toyota that was mimicking GM in its strategy in North America, rather than the other way around. Another year or two of breathing room would have made all the difference.