Home » Articles » What Are the Options for U.S. Automakers?

What Are the Options for U.S. Automakers?

How It All Started

You may have heard that America’s Big 3 automakers are in a bit of a pinch. In late November, the automakers concluded testimony in front of the Senate Banking Committee. The often tense atmosphere of those sessions suggests just how desperate things have become for Detroit.

But the news isn’t all new. Some would argue that the competitiveness of U.S. automakers has been declining for more than 30 years. Ever since the ascendancy of Japanese automakers Honda, Toyota and Nissan, the Big Three have been a bit slow to react. As recently as the first quarter of 2007, and for the first time in history, Toyota surpassed GM as the world’s number one automaker. That quarter, Toyota sold 2.37 million cars worldwide, to GM’s 2.35. That slim margin has increased since, revealing the larger trend behind the numbers GM and the other U.S. automakers are no longer as competitive as they were.

Causes of the Crisis

Ironically, the decline started in the early 1970’s, the last time there was a large spike in oil prices. That spike subsided, however, and the Big Three started putting all their efforts behind manufacturing large trucks, vans, minivans and SUVs. Those vehicles have come to dominate American roads and highways, and U.S. automakers’ product lines, and that dominance has in part led to the current crisis the U.S. auto industry faces.

The most recent spike in gas prices in the spring and summer of 2008 saw an unexpectedly large number of American consumers change their preference from larger trucks and SUVs to smaller, more efficient models such as the Toyota Corolla. The move exacerbated an already significant trend away from American cars to foreign models, especially Japanese ones. And the Big Three’s unabated, decades-long push toward larger, less efficient models made the switch away from them that much more severe. And worst of all, perhaps, American companies have only recently begun investing in fuel-efficient and hybrid models. But as fuel prices starting climbing in 2008, American consumers could already choose from a number of Japanese hybrids, including the Honda Civic hybrid and, most notably, the Toyota Prius.

There are other reasons for the Big Three’s decline.

Not least of these are the decline in the quality of their car models and the apparent inability of management teams to see its effects in eroding market share, much less be able to do anything about it. So-called “light trucks”, for example, represented 55% of all vehicles sold in the U.S. in 2005. That number had already declined dramatically, to 47%, by the middle of 2008. It’s also no secret that Ford’s management of its popular Taurus line led to declines in Taurus quality, not to mention features and design. While the model was popular in the 1980’s, managements’ failure to update the model led directly to the Toyota Camry and the Honda Accord quickly becoming American consumers favorite sedans.

Critics point to one final likely cause of Detroit’s decline, the high labor cost of its cars, a holdover from its earlier days of profit and prosperity. Recent estimates peg GM’s employee benefits cost at over $2,500 per vehicle: $1,635 in health care costs (for both existing and retired employees); $650 in holiday and other work-related leave pay; and $350 in the salary costs for paying workers during times when plants are closed. Recent negotiations between the three carmakers and the United Auto Workers (UAW) union have acknowledged the need for change, and both sides have made concessions. Most notable among them are UAW agreements to accept lower pay for incoming workers. But unfortunately for Detroit’s automakers, the moves may represent too little effort, too late. It’s well-known that Japanese firms have generally insulated themselves from similarly difficult choices by locating plants in the South, away from the long-time union strongholds of the Midwest, particularly Michigan.

The Financial Impact is Sobering

Of course, these business decisions have had a huge financial impact on American automakers, which has played out in the media, most recently with regard to the Senate hearings mentioned earlier.

The numbers are sobering. Ford reported a $2.98 billion operating loss in the third quarter of 2008. GM lost $4.2 billion that same quarter. And the two automakers burned through a combined $14.6 billion in cash in the quarter. GM has already decided to cut its 2009 capital budget (i.e., the amount it invests in assets, such as plants, new equipment and infrastructure) by $2.5 billion. The move highlights the biggest issue facing any company concerned about financial survival, whether a struggling automaker or a recently launched venture,  conserving cash.

The automakers struggles also perfectly illustrate the intimate connection among the income statement, the cash flow statement, and the balance sheet; unfortunately, in the case of the Big Three, their dramatic losses and the resulting negative cash flow have brought the balance sheet down with them.

The balance sheet, of course, is simply a way of keeping track of what the company owns and what it owes:

Balance Sheet Formula

Any profits that a company has left over at the end of a fiscal quarter eventually make their way to the balance sheet as retained earnings, in other words, profits not paid out to creditors or investors. Retained earnings represent a surplus of assets (what you own) over liabilities (what you owe), or what a company is worth (also known as equity).

In the case of the automakers, there were no positive profit numbers for the third quarter of 2008. The companies all reported a loss. That means they made less than they spent. And that difference, of course, had to come from somewhere. The companies had to sell what they owned or deplete their cash; in other words, they were forced to reduce their assets.

Detroit’s recent string of quarterly losses and negative cash flow has set in motion a dangerous downward spiral that ultimately reduces both assets and owners’ equity:

Detroit Balance Sheet

This series of events explains why the automakers are in Washington. They are asking for cash to be able to meet their obligations, both to outside creditors (suppliers, banks, etc.) and internal ones (primarily employees and pensioners). Ultimately, the Big Three need cash to stem this tide and prop up their balance sheets, and their businesses, some would argue only temporarily.

Of course, the rapid reduction in owners’ equity has one final, and devastating, effect, the company’s lower value in the marketplace, which is tied directly to the worth (or equity) recorded on its balance sheet and reflected in a lower stock price. As a result, Ford’s stock is down from an already dismal $6.64 in January 2008 and is currently hovering between $1 and $2. GM’s far healthier stock price of $27.60 in January of 2008 has dwindled to little more than $3 near the end of the year. Credit rating agencies have already downgraded all three automakers to junk status.

So what’s next for the automakers? We look below at the two options open to them.

Option 1: A Bridge Loan

The Senate hearings have revolved around a single decision: whether to offer the automakers a $25 billion lifeline. Although some in the media have referred to it as a bailout, the lifeline in this case is in the form of a bridge loan, in other words a loan meant to help the companies survive what they argue is a short-term downturn in their markets and product lines. The companies point to recessionary fears, declines in consumer confidence and spending, and credit shortages for even qualified vehicle purchasers as the culprits for their troubles. As evidence, they point to their Japanese counterparts, who have also experienced a slowdown in sales in recent months, both in the U.S. and internationally.

The term bailout applied to the aid package to automakers being considered on Capitol Hill more accurately refers to the presumed source of loan funds, the $700 billion assistance package passed by both houses of congress to help avert a financial and credit crisis. By pointing to the current worldwide credit and financial crisis as the root causes of their troubles, the automakers are making a dual plea: they’re attempting to downplay the responsibility of management for their recent troubles; at the same time, they’re attempting to argue for the right to tap into a fund set aside to help avert disasters stemming directly from the current financial crisis. The Bush administration has argued instead for using loan funds from a fund set aside to help the Big Three improve fuel efficiency in their vehicle lines.

What’s become clear in the discussions is the demand on all sides for a renewed emphasis not only on fuel-efficiency but, more fundamentally, better management and organizational and financial restructuring at the Big Three. In a November 17th 60 Minutes interview, President-elect Obama echoed the call to attach strings to any purported aid package, arguing that any such package should be conditioned on labor, management, suppliers, lenders, all the stakeholders coming together with a plan. Considering GM and Ford’s cash burn rate of nearly $15 billion in the third quarter of 2008 alone, it isn’t difficult to see the general concern lawmakers have expressed about the health of the Big Three and the more specific fears occasionally voiced that even a $25 billion loan package would last only several months and would be equivalent to throwing good money after bad.

The current plan being considered on Capitol Hill includes, therefore, a number of strings, tempered with a sense of just how serious the current crisis is for the automakers. The specifics of the plan are still being discussed. But a number of provisions have been floated, including charging the Big Three an initial rate of 5% on the loans, which would later rise to 9%. Any plan, however, will almost surely include direct and rigid oversight by the administration, by way of the Treasury Secretary and other top-level administrators and Cabinet members, who would have the power to veto any expenses that topped $25 million, in order to ensure that taxpayer funds are going directly to help the companies survive. According to some estimates, allowing the automakers to collapse would push 3% of the U.S. population directly and indirectly involved with U.S. auto manufacturing, including employees, suppliers, and dealers, into unemployment.

The automakers themselves have also recently discussed the possibility of mergers, GM, for instance, has been in merger talks with Chrysler. That possibility is more directly related to the other, less palatable, option for automakers, bankruptcy.

Option 2: Chapter 11

The bankruptcy option on the table for one or more of the Big Three is what’s known as Chapter 11, a re-organization. (Chapter 7, a forced liquidation, has yet to be discussed.) Chapter 11 would allow the automakers to fend off creditors (including the UAW), sell off lower performing divisions and/or brands, close some plants, and possibly merge into two or even one entity, which, it’s hoped, would help create several billion in cost reductions.

The move would also allow the merged companies to combine automobile models. Those models have been proliferating for the last two decades, with considerable overlap across companies and within company brands, and in particular at GM. The Cadillac Cimarron, for instance, first offered in 1982 (as a 1982 model), was simply a retooled upscale version of the Chevrolet Cavalier. That same year, the Cimarron earned TIME magazine’s designation of the worst car ever produced. It was finally discontinued in 1988.

Declaring bankruptcy is a more recent addition to the discussion of possible options for the automakers. But if a loan package can’t be worked out soon, it may be the only option left. GM Chief Rick Wagoner has recently said that the company would not be able to survive beyond 2008 without an immediate cash infusion.

If any of the automakers do file for Chapter 11, its chances of successfully emerging from the bankruptcy would increase the earlier it made the move. And as soon as it did, the U.S. government might still need to offer what’s known as “debtor-in-possession” financing, as a way of helping the company through the process. In that instance, the loan amount, and the risk, would presumably be far less than they are now.

The government would also need to find a way of backing the warranties of existing and new cars, until the company makes it out of Chapter 11. Otherwise, of course, few consumers would opt to purchase a vehicle from the company that has filed for Chapter 11 protection, which would negate all the efforts on the company’s behalf.

And finally, if any of the automakers declare bankruptcy, whether Chapter 11 or Chapter 7, the government may also need to consider stemming the likely tide of unemployment and lost pensions by offering help. For instance, the government may need to help those who lose their jobs financially or through various re-training programs, especially in Michigan and the rest of the Midwest, where the automakers are concentrated. And the FDIC (the Federal Deposit Insurance Corporation, which guarantees bank deposits), or some other federal agency, may need to shore up pensions of retired employees.

Now that talks between GM and Chrysler have slowed, the possibility of a merger between any of the Big Three, certainly outside of Chapter 11, seems remote. Considering the automakers combined difficulties over the last few months, some have compared the prospect of combining two or all three of them to the expectation of creating a healthy patient from two or three unhealthy ones. The grim humor of that sentiment may tell us almost as much about Detroit’s business and financial problems as it does about just how seriously the car companies have stumbled, and how far they’ve fallen.

Sign Up for Online Financial Training

Looking for training on the income statement, balance sheet, and statement of cash flows? At some point managers need to understand the statements and how you affect the numbers. Learn more about financial ratios and how they help you understand financial statements.

Our online training provides access to the premier financial statements training taught by Joe Knight. Learn finance in a fun and clear way that’s easy and painless.

You’ll be trained by the firm that brought you the Harvard best seller!

“It reads easily without dumbing down, and it’s comprehensive.” CFO Magazine

It’s been transformed into a comic book!

“A fun, easy way to teach a quick introduction to finance.” Joe Knight, co-author

Selected as one of the “100 Best Business Books of All Time”

“What I like best about Financial Intelligence is the fact that I can read the book and never see the words debit or credit.” Todd Sattersten, co-author of The 100 Best Business Books of All Time