Ford focus
Mar 16th 2004
From The Economist Global Agenda
By Buttonwood
SourceWith stockmarkets looking shaky once again, the auto sector would seem to be a particularly bad bet
NO PETROLHEAD, Buttonwood used to drive a Honda people carrier, and now toddles around in a Fiat Punto, a modest car with much to be modest about. Still, he dreams of something with a little more elan, when finances permit. That something is unlikely to be made in Detroit. Even so, the unenticing nature of the cars that the Big Three carmakers—Ford, DaimlerChrysler and General Motors—generally produce there is as nothing compared with their shares, which Buttonwood regards at current prices as no less repellent than a 1958 Edsel Bermuda (the one with the wood panelling). Investors, it seems, are starting to agree. Having fallen by 17% so far this year, the auto sector is one of the worst-performing in the S&P 500, where competition is stiff; Ford’s shares have dropped by a quarter from their peak in January. The sharp rise in carmakers’ shares last year now looks like having been the triumph of hope over reality.
Put bluntly, the short-term outlook for the Big Three is dreadful. For one thing, rising commodity prices are pushing up the costs of the things from which they make their cars. Manufacturing overcapacity (of around 20% in North America) and inefficiency mean that in any case they are making at most $300 on each car they sell. And they are able to sell as many as they do only because they lend customers the money to buy them for just about nothing.
Punters seemed happy to invest in the sector so long as they were reasonably confident about the future. That confidence seems recently to have taken a sharp knock, in part because America’s economic recovery is producing so few jobs, but also, since the terrorist attack in Spain last week, because of renewed fears about security. Cyclical stocks, such as advertising and media companies, have been hit; airlines have been vying with car companies for the wooden spoon.
Cars have been piling up on dealers’ forecourts, which in January had on average 88 days’ supply of unsold cars on them—and probably more now. To shift these cars, the Big Three are having to spend even more on incentives and marketing, just when investors thought that they might be able to spend less. So far this year, GM has been spending $4,141 per car on promotion costs, compared with $3,253 in the same period last year, and some $2,000 in 2001, according to J.P. Morgan Chase. The trend is also up at Ford and Chrysler.
If anything, the long-term outlook is worse. There are, for a start, huge pension obligations. Last year, GM issued bonds worth $17 billion to plug this gap. Ford did the same later in the year, though not on the same scale. Quite how issuing debt does anything at all to reduce pension liabilities, except by accounting sleight of hand, is beyond Buttonwood’s understanding—the firms’ actuaries assume, dubiously, that they will make more money investing the proceeds than it costs to raise them. The Big Three also have huge health-care costs. According to Ron Tadross, an auto analyst at Banc of America Securities, their combined health-care liabilities amount to $60.4 billion. “Basically, they have no discretionary free cashflow,” says Mr Tadross. Almost all of the money they earn goes into paying debts.
That GM and Ford in particular survive at all is thanks mainly to the largesse of their finance arms, General Motors Acceptance Corp (GMAC) and Ford Motor Credit (FMC). Over the past decade, the finance subsidiaries of the Big Three have transferred about $600m a year to their manufacturing arms, says Mr Tadross. This year, GMAC will hand over some $2.4 billion and FMC about $2 billion. The business of America, it sometimes seems, is finance.
Which makes the car firms’ credit ratings hugely important, for without a decent rating, the companies would not only find their debts more expensive but their competitive advantage in finance eroded compared with banks, which as a group are being upgraded. Alas, all of the Big Three have had their ratings slashed in recent years, to within a sniff or two of junk. Standard & Poor’s currently rates Ford BBB- (the lowest investment-grade rating), though the carmaker is rated a touch higher by Moody’s. For now, at least: bond markets are again being spooked by the auto companies, and vice versa. The spread of Ford’s bonds over Treasuries has widened dramatically over the past couple of weeks, and those issued by the other two have performed none too well either. If Ford were to fall to junk, its financing costs would rise to levels that were probably unsustainable. In 1992, GM was said to be within an hour of going bust, with its bosses waiting by the fax machine for the ratings downgrade that would have tipped it over the edge.
This is not a problem that afflicts Toyota, which carries a rock-solid AAA rating from Standard & Poor’s and spews out more cash than a salaryman on a golfing holiday. Japanese carmakers have, indeed, been rapidly eating into the market share of the Big Three. Toyota has taken over from Ford as the world’s second-biggest car manufacturer behind General Motors, and on present trends will become the biggest in the not-so-distant future. So far this year, the Japanese have grabbed 32% of the American auto market, up from 28% in 2002. They also have much lower pension and health-care costs than their American competitors and, it seems, a better range of cars, since Japanese firms spend about a third as much as the Big Three on marketing them. Small wonder that Toyota makes $1,500-2,000 on every car it sells in America—or that Japan’s biggest carmaker has a higher market capitalisation than the Big Three combined.