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March 1, 2009

THE AUTO INDUSTRY WILL SURVIVE

A review of the facts shows why.

The amount of media attention focused on the automotive industry lately is truly astonishing, and most of it is at least partially delusional. I knew we were in trouble when The Wall Street Journal ran an opinion column in November 2008 that referred to Roger Smith, chairman and chief executive officer of General Motors from 1981 to 1990, as “a forward-thinking genius.” There has been so much biased and incomplete information published about the industry that it’s appropriate to try to have a more data-based conversation.

Why We Are in the Current Crisis

While this will be a statement of the obvious, the industry is in crisis for four primary reasons:

  • First and foremost is the collapse of the housing market. There is a major correlation between new housing starts and automotive sales (see chart, “New Home Starts Versus U.S. Light-Vehicle Sales”). When new home sales rose in 1992 and 2002, for example, so did light-vehicle sales, and when new home starts plummeted in 2006, lightvehicle sales also dropped. Until this core market improves, it is difficult to envision a scenario in which auto industry sales improve significantly.
  • Second is the dramatic drop-off in vehicle sales. In 2007, the U.S. seasonally adjusted annual sales rate (SAAR) was 16.1 million units. As late as June 2008, it was still 14.25 million units. From October through December 2008, sales were between 10.2 and 10.5 million units. January 2009 dropped to 9.57 million.
  • This collapse of vehicle sales is primarily linked to the massive decline in consumer confidence. The best illustration of this was a consumer survey conducted by USA Today in December 2008 in which 39% of respondents said they believed the U.S. economy likely would be in a depression within two years. The point of the survey is that, until people feel better about the economy in general, regardless of their personal financial position, they are not going to buy durable goods.
  • The complete freeze of the credit markets is another reason. In almost any other situation, the original equipment manufacturers (OEMs) and suppliers could obtain short-term loans to allow them to manage the downturn. That is not possible given the current state of the capital markets, which led the Detroit Three to seek assistance in Washington, D.C.

Why Things Will Get Worse Before They Get Better

The first quarter of 2009 will be a very ugly three months from an automotive production perspective. While forecasts suggest a U.S. level of 10.2 million to 10.5 million units for the year, firstquarter production annualized levels should come in at around 7.6 million units. That is basically 50% less than the first quarter of 2008. That level of production combined with the lack of access to credit will lead to a number of supplier bankruptcies in the first and second quarters of 2009.

Why is production so low?

  • Most people are not convinced we have hit bottom yet in terms of the economy. While everyone knew the announcements in January would be universally horrific—e.g., continuous job loss announcements, record financial losses, concerns about the stability of the banking system—the fact that we knew the news would be bad does not seem to have helped much.
  • OEMs overproduced in December. We believe at least part of this overproduction was intentional inventory build in case significant suppliers went bankrupt and caused a disruption in supply. It will take at least a few months to work this additional inventory out of the system.
  • Contrary to most popular press, a fair amount of this first quarter decline is due to significant reductions by the Japanese Big Three—Toyota, Honda and Nissan. We believe some of this decline is an overreaction to current conditions—particularly in the case of Honda—but it still has taken a big chunk out of first-quarter production levels.
  • There will be a number of tierone through tier-three bankruptcies announced in the first and second quarters that will cause some industry disruption and a continued negative attitude toward the automotive industry. While this shakeout will be good for automotive suppliers in the long term, with reduction of excess capacity and elimination of marginal competitors, it just adds to the industry’s negative funk in the short term.

Why the Industry Will Survive

The important point to remember is that the overall long-term demand for vehicles has not dramatically diminished because of the current crisis. Yes, there may be some changes in the length of the buying cycle (for example, buyers may hold on to vehicles for an additional year or two), and there may be some downward trend in number of vehicles per household. But that does not mean vehicles have lost their place as an important status symbol for many consumers or that vehicle sales will remain at their current significantly reduced levels.

It is clear that the next several generations of buyers will enjoy new vehicles just as much as their parents did. What those vehicles look like and who makes them may change, but the overall demand for vehicles is likely to return to “normal” levels within a few years. While normal levels may mean 14 million to 15 million units annually versus the 17 million unit numbers we enjoyed through the past few years, it certainly does not mean we will be at the 10-million-unit level that has caused so much industry pain.

The challenge for industry participants is to figure out how to ride out the current storm and take advantage of the weaknesses of their competitors during this very difficult year of 2009.

Kim Korth is owner and president of IRN Inc., a management consulting company in Grand Rapids, Michigan, and is a member of the Society of Automotive Analysts.