Carmageddon: Bankruptcy beckons for America's embattled car makers

By Ben Thompson, Senior Editor

Bankruptcy beckons for America’s embattled automakers as they face a perfect storm of slumping sales, tightening credit markets and changing consumer tastes. These aren’t just tough times for Detroit; this is… CARMAGEDDON.

“The situation for Detroit is dire. These companies have run through their equity and have almost no financial cushion left, and all three are at very high risk of failure.”
-John Casesa, CEO of Casesa Shapiro Group

It’s a big shout, but here it goes: if Barack Obama really wants to make a dramatic economic statement in his first 100 days as the next president of the United States, he could do worse than let the US auto industry fail. It might sound heretical, but hear me out before popping that poison pen letter in the post.

First, the bad news. For an industry that once branded itself as ‘the heartbeat of America’, today you’d be hard pushed to find a pulse. GM recently announced a stunning $15.5 billion second-quarter loss, with further substantial losses expected for Q3. Ford’s share price has crashed to a paltry $2.19, a drop of 54% since the end of Q2. And Chrysler, under pressure from its private equity owners, is desperate to broker a merger to stabilize its position. If the US auto industry was on the sick list before September’s financial meltdown, it’s now on life support.

They should have seen it coming. The product mix in the US, heavily weighted toward increasingly unpopular trucks, pickups and SUVs, is on the wrong side of gas prices. The industry is hamstrung in any efforts to restructure by its crippling labor contracts. And consumer confidence regarding brand quality is at rock bottom. With such long-term issues already threatening to overwhelm them, the last thing Detroit needs right now is a full-blown financial crisis that brings with it tightening capital markets and dealer-shy customers.

Take General Motors, for instance. By any meaningful metric, GM is bankrupt already. Its liabilities are greater than its assets, and its equity deficit amounts to a gargantuan -$57 billion. Most tellingly for a company that reportedly needs $11 billion in working capital on hand at all times to remain in business, liquidity is now a real issue: with current cash reserves of around $20 billion and the company spending $1 billion more per month than it brings in, GM could be out of business inside a year. “Without external intervention from consolidation or government assistance, we expect GM to reach its minimum cash position in under 12 months,” confirmed Deutsche Bank auto analyst Rod Lache in a recent briefing.

The situation at Ford and Chrysler is not much better, and Wall Street’s economic woes are only likely to pile more pressure on those beleaguered balance sheets. The trouble is, raising more cash has proven nearly impossible in the current climate. GM’s attempts to refinance its headquarters building in downtown Detroit are unlikely to raise enough cash to float the company for long, while the sales of other assets are hampered by the company’s current poor valuation and changing consumer tastes (it has been trying to offload the gas-guzzling Hummer brand for months). Ford was smart enough to put all its assets, down to the iconic blue oval logo, in hock for $23.4 billion just before credit bubble burst, but even so that cash cushion won’t last long given its current burn rate. And with Standard & Poor’s downgrading the firms’ credit ratings further into junk territory, Detroit’s ability to borrow its way out of trouble is limited.

“The situation for Detroit is dire,” admits John Casesa, CEO of automotive industry consultancy firm Casesa Shapiro Group. “These companies have run through their equity and have almost no financial cushion left, and all three are at very high risk of failure. They’re all very dependent on North America and they’re all very dependent on large vehicles. I’d say that every day the chances of a recovery are diminishing.”

Last chance saloon

All three have insisted that bankruptcy is “not an option” – but then they would say that. No one wants to buy from a firm that might not be around in a few years time, and further hits to sales at a time when the market is already experiencing a prolonged period of contraction would be disastrous.

The problem is that the alternatives are not particularly palatable, either. After a brief flirtation with Ford, GM is now in advanced merger talks with Chrysler in a move that would see America’s first and third largest carmakers unite. But George Magliano, an analyst with research firm Global Insights, believes the jury is still out on whether a merger would be a good move for either firm. “Basically it would be a cost cutting move by General Motors, a way of wringing people out of the system and closing plants,” he says. “I’m sure GM also has some interest in acquiring the Jeep brand, but beyond that it’s a difficult sell. They both make a lot of big trucks, they both make a lot of big cars, and both have major deficiencies on the small car side, so the synergies that you’d want to see are just not there.”

Indeed, given that one of the main criticisms of GM in recent years has been its bloated brand portfolio, adding further (largely non-performing) lines to its inventory would be a surprising move. A combined GM-Chrysler would have too much factory capacity, too many brands and too many dealers. And while Casesa concedes he is intrigued by the move, he too remains skeptical. “On paper it looks very interesting because GM would eliminate an enormous amount of excess capacity in the market, essentially by closing down Chrysler’s capacity,” he explains. “It would add Chrysler’s cash reserves of about $10 billion to GM’s balance sheet, which it desperately needs, and it would eliminate a competitor that’s hurting pricing in North America. So on paper, consolidation makes a tremendous amount of sense.”

In reality, however, the move faces some significant challenges. “These combinations are extremely difficult to execute,” continues Casesa. “There will be labor opposition. The factory production systems are totally different. And there will have to be a tremendous rationalization in terms of dealer capacity and that’ll cost some money. It’s an extraordinary integration challenge, because even though these companies are small on market cap, they’re very big in terms of people, facilities and complexity. If you look at the track record of these large auto combinations – going back decades – very few have been successful.”

And while some estimates suggest the new entity could save more than $5 billion a year by running the two companies as one, it could take years to realize these savings. Renault and Nissan are still completing their consolidation, even though the companies joined in 1999 – and neither faced the combined challenges currently confronting GM and Chrysler. Time, of course, is something Detroit does not have.

Help wanted

One remaining lifeline for the struggling carmakers is the prospect of federal assistance. Washington has already approved a $25 billion loans package to help auto companies meet new fuel efficiency standards, but the recent banking bailout has raised hopes that further funding might be found if the auto industry faced failure. “Every bit helps right now, but the $25 billion on its own is not sufficient to save these companies,” says Casesa. “They need to continue successfully restructuring their businesses and adjusting to a radically changed market. That will take a lot more time, which will require a lot more money.”

The question is whether the government has the appetite for further bailouts. After all, Detroit’s problems have been evident for decades, and the majority view is that poor decision-making and inefficiency over the long-term are the chief problems, rather than the current economic crisis. “The threat of a financial meltdown brings back the specter of the 1930s here, and nobody wants that,” says Magliano. “But I think Washington feels that Detroit’s problems are of their own making, and therefore, if bankruptcy were an issue, then so be it.”

Casesa takes a similar view. “ It is one thing to bail out the financial system, which is obviously a systemic problem that affects all facets of the economy. It’s a different thing altogether to bail out just one sector. And while there’ll be more sympathetic ears than there used to be because of the turmoil in the economy, the long-term bias is that these companies created their own problems. And I guess if you bail out the auto industry, who’s next? The airlines? We could have industries queuing round the block for federal handouts.”

It’s an unedifying spectacle, but the clamor for cash is only going to grow louder as the economy sinks deeper into recession. Inside the merger negotiations, the growing feeling is that a combined GM-Chrysler entity, while daunting in its complexity, may be the best way to bring federal money into the mix. And in something of a ‘me too’ move, Ford has also ensured it is in the frame for any handouts should they be available, with EVP Mark Fields asking for “a degree of parity”.

The ultimate sacrifice?

But here’s where things get interesting – because even with these interventions, the industry’s long-term future is hardly assured. For starters, even if they were to retool and start producing more fuel efficient vehicles, who is going to buy them? The US consumer is strapped for cash and access to credit to buy a new car is almost gone; extremely few consumers buy new cars for cash, anyway. There is a growing feeling that by bailing out Detroit, Washington could just be throwing good money after bad. It’s no use propping up the industry without first propping up the very thing it depends on – the consumer.

Analysts are predicting tougher times ahead, too. Jeff Schuster, Executive Director of automotive forecasting for industry analyst JD Power and Associates, predicts that a pronounced recovery is at least 18 months away. “While the global automotive industry is clearly experiencing a slowdown in 2008, the global market in 2009 may experience an outright collapse,” he says. “These firms’ CreditWatch placement reflects the rapidly weakening state of most global automotive markets, along with capital market conditions that will remain a serious challenge to liquidity during 2009.”

It begs the question: what would happen if Washington let one of the Big Three go under? First of all, it would be far from easy. While the direct impact on the national economy would be relatively modest, it would deal a significant blow to the rust belt states in terms of job losses and retiree benefits cuts. According to the Center for Automotive Research, domestic car companies and their suppliers employ some 600,000 line workers; factor in firms that indirectly rely on the industry for work, and up to 3.6 million people could be at risk. Michigan already has the worst unemployment figures in the country.

In addition, the taxpayer would be on the hook for billions in retiree benefits, with the federal government’s pension-guarantee program likely to be swamped by the addition of hundreds of thousands of retirees. For decades, Detroit’s Big Three have funded generous programs to take care of former workers and surviving spouses; GM alone provides healthcare and pensions to about 480,000 hourly and salaried retirees, and has committed to pay out $64.14 billion in pension benefits to US retirees between 2009 and 2017. Were it to place its pension burden on the government’s Pension Benefit Guaranty Corp. (which ended 2007 with a $14 billion deficit), it would more than double the agency’s current shortfall – a burden that could fall on taxpayers.

But these issues notwithstanding, Casesa believes there is actually an argument for letting at least one of the Big Three fail and allowing the market to right itself. “That’s the stronger argument,” he insists. “If you look back at the Chrysler bailout in the early 1980s, with the benefit of 25 years’ hindsight it’s hard to see what was so strategic about that move. It was the smallest of three companies and if it had failed, I think maybe it would have had a very motivating effect on Ford and GM. So my own view is we should let the market work.”

Magliano agrees. “If one of the Big Three went bankrupt, somebody else would take over that void in the market,” says Magliano. “It’s not the same as when they bailed out Chrysler in the 1980s. The import nameplates are now making a lot of vehicles here, and they show a commitment to manufacturing in the US. It’d be one thing if we were going to import vehicles to make up the shortfall, but I don’t think that’s on the cards. If somebody in Detroit did go bankrupt, someone else would just pick up the pace.”

No such thing as too big to fail

If anything, bankruptcy would do the carmakers some favors, affording them protection from creditors and allowing them to restructure without the straightjacket of prohibitive labor and supplier contracts. As to the argument that entering into Chapter 11 would hurt sales and stigmatize that company, one need only look at the example set by the airlines a few years back to see how such a situation would most likely pan out: once one firm declares, others would soon follow in order to share in the cost savings and leaner operating profile, and prevent any one company from gaining a competitive advantage. Sure, it felt odd to fly a bankrupt airline at first, but once practically the entire industry had followed suit no one gave it a second thought. If GM were to file, you can bet your bottom dollar that Ford and Chrysler would not be far behind.

Tired brands and unprofitable dealers would disappear and the companies’ remaining resources could be focused on those products and dealers with the greatest strength and staying power. They might even emerge from the experience as efficient, competitive organizations. “Failure is only the opportunity to begin again more intelligently,” Henry Ford once said, and there’s a good deal of truth in that statement.

Finally, any government funding – rather than being poured into prolonging the death throes of an industry in terminal decline – could then be used as seed money for innovative ideas on how to take the industry forward, not merely as sawdust on the oil spills. This could be the start of a new age of American innovation, and a domestic auto industry that offers scope for emerging players with pioneering ideas such as Tesla and Better Place. The future belongs to firms with greener vehicles, cleaner technologies and more efficient solutions; given a level playing field, none of the current Big Three would survive.

Could this be the end of America’s love affair with Detroit? In 1948, William Faulkner noted that “the American really loves nothing but his automobile,” and there is little doubt that the story of the US has been the story of the car, plain and simple. But while the American still loves his automobile, that car is just as likely to be made by a Japanese or German company as it is by a domestic firm. “ The US car market is dying,” concludes Peter Schiff, President of brokerage firm Euro-Pacific Capital, bluntly. Be brave, Mr President. Let nature run its course.

Extra Info...

Why bankruptcy beats a bailout
Many analysts believe Detroit would be able to work through its problems provided it had the resources available to ride out the next 18 months. However, the real flaw in having taxpayers bail out the Big three is that it spares the companies from bankruptcy reorganization – the very process they need to get their costs and structure in line with market realities. Only a bankruptcy court can:

REDUCE the burden of pension and health benefits that are slated to cost the companies $90 billion over the next decade
OVERRIDE state laws that make it difficult and expensive for them to pare back a gargantuan dealership network

IMPOSE on members of the United Auto Workers pay and benefit packages comparable to those paid at the non-unionized plants of foreign manufacturers
Infographic: 600,000 - Number of US auto industry manufacturing jobs, including suppliers

In the next 12 months, US auto sales could sink to levels last seen during the recession of the early 1980s. Sales peaked at 17.4 million in 2000 and remained near 17 million for five more years. This year, 13.6 million vehicles are expected to be sold, and sales are expected to fall by another 500,000 vehicles in 2009, according to consumer-researcher JD Power & Associates.

Autocalypse now
Detroit’s Big Three are all headed for the scrapheap. The question is, when?

Chrysler
In terms of product sales, Chrysler is the most concentrated in North America and the most concentrated in bigger vehicles – the two markets hardest hit by the recent economic turmoil and oil-price spikes. While Chrysler is no longer required to disclose its finances due to the recent takeover by private equity group Cerberus, the deal is widely held to have been a failure and is likely to result in a fire-sale as the new owners look to cut their losses. If the merger with GM goes ahead, expect the firm to be broken up, plants to be shut down and thousands to lose their jobs; if it doesn’t, expect the firm to be broken up, plants to be shut down and thousands to lose their jobs. Tough times indeed.
Cash on hand: $10 billion (estimated)
Judgement day: Imminent

General Motors
GM is in real trouble. Stock prices, since peaking near $94 in 2000, have been in freefall for the last few years and plummeted to a barely conceivable 58-year low of $4.65 in October. The company is banking on innovations such as the new Chevy Volt to kickstart sales, but even then an expected due date of 2010 may come too late to save ‘The General’ from going under. After the briefest of talks with Ford, GM is now desperately seeking a union with Chrysler – although insiders believe this will only exacerbate its problems of too many product lines, too many dealers and too much capacity. The deal is purely about GM getting its hands on Chrysler’s cash reserves and increasing the likelihood of federal money being brought into the mix.
Cash on hand: $19 billion
Judgement day: Inside six months

Ford
While GM and Chrysler thrash out their ill-conceived merger, Ford is forging its own path. And while the Dearborn team may have more cash on hand than its rivals thanks to some canny re-financing shortly before the collapse of the capital markets, the future is just as bleak. Here are some frightening scenarios: if either of its more troubled competitors enter bankruptcy protection, they will automatically reap the benefits of creditor protection and forced union contract renegotiation; if they merge and get federal assistance to help with the restructuring, Ford will essentially be competing against a part-nationalized company. Can it compete on those terms? Not likely. Despite its determination to remain free of the stigma of Chapter 11, expect Ford to follow suit and file shortly after.
Cash on hand: $26.8 billion
Judgement day: Late 2009