Tuesday, January 24, 2006

Car race

Are we a car company or a finance company that happens to sell cars?

This is the fundamental business question facing GM and Ford. As these US-based companies continue to lose market share to Toyota, Honda, and Nissan, it is becoming clearer that the US companies are losing market share because finance has become the tail that wags the dog. For instance, Ford earned $2 B in 2005 because it generated $6 B in operating profits from its finance arm while losing $4 B making vehicles. For the first nine months of 2005, GM limited its $6 B in vehicle operating losses due to the $2.2 B it made financing those vehicles.

GM and Ford can’t cut their way to success in the car business. Both are operating their plants at about 80% of their manufacturing capacity. Their recent capacity reduction announcements – GM announced a 19% capacity cut while Ford’s was 26% -- are designed to bring them closer to 100% capacity utilization. But at the rate they’re losing market share, the US auto companies will find that once they’ve reduced their capacity, it will still be too high because demand will have shrunk. Meanwhile both companies have seen their stock plunge in the last year (GM -44%, Ford -40%).

It’s worth considering why Toyota, whose stock has risen 30% in the last year, is surpassing its US competitors. The first reason is that people want to buy Toyota cars. Toyota cars – particularly Lexus -- top the initial quality surveys year after year. And people are willing to pay for that quality. For example, Toyota charges 14% more for their average vehicles ($24,500) than GM ($21,000).

Toyota also builds cars faster and at lower cost. Toyota can build a car 7% faster (in 21.63 hours) than GM (23.09 hours). Moreover, Toyota enjoys a $300 to $500 per vehicle cost advantage over GM. Part of this advantage is in health care costs. While GM complains about its $1,500 per vehicle health care charge, Toyota makes most of its cars in countries where government picks up much of the health care bill.

Even though it charges higher prices, demand for its cars is so high that Toyota is operating at full capacity and it appears poised to take over the North American market share lead this year. Meanwhile, Toyota earns an average of $1,488 per vehicle in profit, while GM loses $2,300. In its most recent fiscal year ending March 2005, I estimate that Toyota earned $12 B in operating profit selling vehicles and an additional $1.6 B financing them.

Speaking of financing, GM and Ford are not doing too great a job of financing their own operations. GM has almost $13 in long-term debt for every dollar of equity while Ford carries $10 of debt per equity dollar. And debt rating agencies are none too impressed – having downgraded both to junk status.

While I would like to think that GM and Ford can transform themselves into makers of the world’s highest quality vehicles, I doubt that’s realistic. A more likely survival strategy would be for GM and Ford to outsource vehicle manufacturing to China and India and focus exclusively on financing.


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