Europe's Troubles: BMW postscript

...my quick analysis suggests no European OEM will weather the coming storm without taking on a fearful amount of water...

According to an August 16^th Bloomberg post on BMW, discounting is rampant in the German market, while sales are not responding. (According to a friend who has worked in Europe, this phenomenon of phantom sales goes back decades, rediscovered in each recession given that the careers of analysts and reporters of the industry seldom span multiple downturns.) Now I visited BMW's plant in Spartanburg, South Carolina in January 2012; it was running flat out and adding capacity, because the models produced there are global hits, with the majority of output exported. My back-of-the-envelope calculations suggest that plant is about 1/5^th of BMW's global output, given capacity additions in China.

Of course a big slice of those exports go to Europe, which is in recession; overall the region accounts for 30% of BMW's sales. The elimination of the "block exemption" in late 2003 removed restrictions that limited the ability of dealerships to sell cross-border; German stores now compete with those in Italy. As long as the euro lasts, troubles in one large market now spill over to the rest of Europe. [And if the euro doesn't last ... but that's my premise.] Meanwhile growth has slowed in the BRICs, which account for 25% of sales.

So while the European near-luxury makers are more diversified than Peugeot, Renault or Fiat, they too remain vulnerable.

And then there's the massive VW empire, 10 brands including a full range of trucks, and a solid sales base in most markets except the US and Japan -- and it is now targeting the US aggressively. However, with a market share of just over 4%, its footprint simply isn't large enough to generate sufficient profits to offset weaknesses elsewhere (and with a new plant, depreciation looms large, good for cashflow but not the bottom line). To analyze how the firm will weather the looming European meltdown would require piecing together these operations. Analysis is further hampered by the lack of geographic data in the stock analyst reports I've scanned. They may be the best immunized -- but I can't make a case one way or the other.

...Mike Smitka...

Addendum: Pending blog post I spent over an hour discussing the European industry with a retired senior Detroit 3 executive whose career included multiple postings to Europe. He helped point out variations across firms and markets, a level of detail beyond my experience or ability to quickly [this is a blog!] research. More once I hit a comfortable rhythm with my teaching overload this fall, and add nuance to my analysis of Europe.

GM and the Upcoming Presidential Election

Ruggles – September 2012

Amid the political turmoil of election season the rescue of the domestic auto industry by the George W. Bush administration and the Obama Administration is certainly a political football. The President and the Democrats have to defend the fact that the “rescue” wasn’t done perfectly, although a debate rages over exactly what those imperfections might be and who is responsible for them. Many Republicans are sticking to their position that the domestic auto industry should have been allowed to liquidate and eventually reform, although that logic doesn’t play well in the key “swing states” Ohio and Michigan. Governor Romney was adamantly against the “bailout” saying “Let Detroit go Bankrupt” and declaring that “a bail out would insure their failure.” Of course, this is all confused by Romney’s attempt in the Republican debates to actually take credit for the rescue saying, “They took my advice.” (His campaign has repeatedly declined comment when asked to clarify their candidate’s position on the issue.)

It also seems to ignore the fact that in the case of liquidation, there would have obviously been a huge cost dropped on the various states for unemployment compensation, a ripple impact through the banking system, chaos in the supplier base, and a disruption of military procurement. The ultimate result could have been a true Depression. Most pragmatic politicians wouldn’t have taken the risk, despite rhetoric to the contrary.

Some of the criticism leveled at supporters of the auto manufacturer rescue is based on the fact that if GM stock were liquidated today, based on its current value which is down a third since its’ IPO date, the taxpayers would sustain a loss in the tens of billions of dollars, which is entirely true. Of course, no one has calculated the cost of NOT doing the rescue, a calculation which would have to be based on speculation and would be subject to considerable argument.

Another issue rarely heard has to do with the billions of dollars of pension liabilities that would have been dropped on the Pension Benefit Guarantee Corporation. While a close estimate of that financial burden is not available, a comparison is. When United Airlines dropped their pension liabilities on the PBGC about 8 years ago as a part of their Chapter 11 bankruptcy, the amount was $6.6 billion. While this is technically an insurance fund, the obligation for pension obligations abrogated by liquidating OEMs and suppliers in the case of an auto industry liquidation would have easily run into the tens of billions of dollars, rendering the fund insolvent. This would have either landed on the back of taxpayers or pension checks would have ceased for many retired Americans. The impact on the psyche of the country and on consumption in the economy can only be imagined.

In the meantime, President Obama and Governor Romney and their political parties have both been banned from GM properties until after the election. There will be no political grandstanding on bailed out automaker facilities! Imagine banning the person who represents one of your largest stockholders, without whom you would not exist.

The two automakers have also refused to furnish vehicles for the national political conventions. It’s a smart move for GM and Chrysler to stay away from politics when possible. After all, they want to sell vehicles to both Republicans and Democrats.

While things are somewhat different for Chrysler now that FIAT has bought out the Federal Government’s stake, are GM executives hedging their bets in case President Obama loses in November? While it hasn’t been talked about a lot, it has occurred to more than a few GM stockholders (myself included) what would happen if Romney is elected and immediately dumps all of the government’s stock in General Motors. This would certainly be devastating for the stock price, but what does Romney have to lose? He could claim to have relieved of GM of its Government Motors moniker, while hurting millions of private stockholders. He could blame the losses on the previous administration, and move on. If reelected, it is a given that President Obama would hold on to the GM stock, selling small amounts at a time to maintain the stock price, while hoping the improving economy would further bolster the value of the taxpayer’s stock.

It is also a given that President Obama’s role in the restructuring in the domestic auto industry gives him a serious advantage in the November election. It is hard to imagine Ohio and Michigan going Republican. And without those two states, the road to the White House becomes a near impossible journey. And if GM shareholders across the country get wind of Romney’s intent to dump the taxpayer’s GM stock at once, it could impact the way people vote in other closely contested states.

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...