It’s actually fairly simple and quite intuitive in terms of what’s been happening in the automotive sector. High oil prices (fuelled by supply concerns, emerging markets demand, geopolitical instability, and a certain degree of speculation) have translated into over $4 a gallon gas in the U.S., and higher gas prices in the rest of the world (in Europe, the cost of gas can be double that of the U.S.). In case you haven’t noticed, North Americans tend to love their giant SUVs. The soccer mom in downtown Toronto driving her 4 kids to school in a Suburban, and the beer-drinking gun-slinging all-American badass driving his Ford F-150 in Alabama all of a sudden is paying $100 for a single tank of gas.
In any type of economy, a $100 tank of gas is going to hit the bottom-line of basically everyone. Joe Sixpack feels it, and I’m sure whoever is funding Al Gore is feeling the pain too, as he jetsets around the world burning up sweet, sweet fuel. Couple the high cost of gas with the steep drop in house prices (some estimates now indicate an 18% to 20% drop in prices peak-to-trough), and you’ve got a bit of a problem. All of a sudden, people aren’t able to tap the equity in their homes for cash. All of a sudden, people are having more trouble keeping up with their mortgages as the rates on their ARMs readjusted. All of a sudden, that gas-guzzling SUV looks a lot less attractive.
This is a double-whammy for automakers. They are selling fewer autos overall due to the economic slowdown (consumers have less money to spend) and they are selling lower-margin cars, as opposed to trucks and SUVs. Now, automakers literally cannot move fast enough to shift production towards smaller, more compact cars. Many top level executives and industry observers have noted that they have never seen a demand shift occur so rapidly.
The automakers are getting smoked on other fronts as well. One of the key reasons why losses at the automakers have been so stunning is the sheer size of writedowns they are incurring. Now, you may say, “wait a tick-tock, these automakers aren’t banks, and they don’t have all these toxic subprime loans sitting on their balance sheets, so what’s the dealio?” Then I’d say, “dealio… really?” I’d also then tell you that in fact it makes perfect sense for automakers to take writedowns, and in more than one way. First off, leasing vehicles is a considerable part of their business model (or at least used to be). At the end of the lease, they get the automobile back. Unfortunately, the residual value of these autos has fallen off the map, and the companies are being forced to mark them to market. Secondly, each of these companies has financing units (GMAC & Ford Motor Credit Co.). The writedowns here are just common sense – fewer people are able to keep up with car payments, more bad loans, thus, more writeoffs. (As an aside, these financing arms also made some forays into residential housing mortgages a few years back when they were going gangbusters – looks like a big mistake now).Chrysler actually just announced that they will be leaving the leasing business all together.
The shift in the automotive market has resulted in some truly mind-blowing 2Q numbers from automakers. Last week, GM reported a $15.5 billion loss for just the second quarter. A week earlier, Ford posted an $8.7 billion loss for the same period. Lord only knows what happened at Chrysler when Bob Nardelli realized the amount of red ink on his P&L this past quarter (Chrysler is now a private company owned by PE firm Cerberus). The only real question now is liquidity. Simply put, do these companies have the liquidity to keep them going through the next few years, let alone the next few quarters? They are burning cash at an unprecedented rate. GM is expected to burn about $12 billion in cash this year, $2 billion in 2009, and $5 billion in 2010 according to some analyst’s estimates. Ford’s going through cash faster than Michael Moore goes through cheeseburgers. It’s estimated that they will burn about $13 billion in cash this year alone. Both companies seem to have some liquidity, but it certainly won’t last for long. Ford currently has about $26 billion in cash on the balance sheet, while GM is at about $21 billion.
Management at GM recently indicated that the “minimum required cash” needed to function properly is $11 to $14 billion. It’s pretty simple math to see that at the current rate, GM will reach this level pretty soon without substantive action. GM plans close four truck plants in coming years and raise $15 billion more in liquidity by the end of 2009, through cost cuts, asset sales and asset-backed financing. While this plan was generally well received by investors, GM’s market cap remains at $6 billion – it’s lowest point in about five decades.
When you’re burning cash at the rate at which these companies are, liquidity does become an obvious concern. However, both of these companies still have a range of options to boost liquidity. They are both engaging in rapid cost-cutting measures, and are downsizing and streamlining their operations. They both have the option of selling assets to boost cash if needed, and possible equity injections. There aren’t too many people out there predicting either of these companies will roll over; however, investors are certainly spooked. As of Thursday, the 5 year mid-price on GMs CDS was 2686 bps (200bps off the all-time high set on Monday) while Ford 5 year CDS was trading at 1801 bps mid (also 200bps off the all-time high). To refresh you all, a Credit Default Swap is a heavily traded type of contract that in essence measures the cost to insure a company’s debt.
These companies clearly face serious issues, but with every bad, there is some good. Both companies have realized that they face a new market. They are taking drastic measures to bolster liquidity, and to turn their ships around. They will burn a great deal of cash in 2008, but most analysts expect the cash burn to slow down through 2010. Moreover, there is always the potential for a stabilization of US sales volumes, a recovering consumer, and a potential fall in oil prices. GM and Ford both still have strong international operations, which have helped to partially mitigate the substantial losses in North America.
This problem is not limited to the Big Three. Even Toyota has felt the impact of high gas prices and a shift in consumer sentiment. On Thursday, the company reported a 28% drop in 2Q08 profit, due mainly to weak U.S. sales and a stronger yen. Last month, Toyota cut its 2008 global production and sales forecast, and scrapped plans to develop the Tundra in North America. In terms of residuals, Toyota booked provisions for losses of 9 billion yen (lower than Nissan’s 42 billion yen and Honda’s near $20 billion yen in provisions.
In Europe, both BMW and Daimler have warned of lower annual earnings. These companies have also relied on bigger, less fuel-efficient cars to drive profitability. The cars where BMW and Daimler make their margins, for instance, the 5 and 7 Series, have seen volume declines. 7 Series sales were down 12% from a year earlier. Mercedes’ Smart car sales rose 27% in July, while sales of Daimler SUV’s fell 19%.
It's not a pretty picutre out there. The prices of the automakers are severely depressed. Does it make them a good trade in the market? Well, it's not for me to tell you that, but clearly, if you think that these companies can rebound in the long-term and can keep ample liquidity in the short-term, then yes, maybe the automakers look attractive. Value investors (such as Warren Buffett) often suggest looking at the long-term staying power of a company. For instance, Buffett owns a large portion of Coke (KO). That company will be here tomorrow, and it's a good chance it will be here in 20 years. Most people used to say that about Ford and GM, especiallly GM. Clearly, that isn't the best statement to make these days. Will they go bellyup? Frankly, in my humble opinion, I don't think the U.S. government would let a GM go bust, but then again, who knows.
