Why Public Support Won’t Save the Auto Industry

abandoned car“Is public support for the auto industry worth it”? It’s a question many have asked. Those who argue against it are painted with “the conservative agenda”, guided by ideology.

But is it ideology or economic reality?

It is true that the auto industry employs thousands of workers, not only directly but also indirectly in related businesses. And there will be a lot of pain, at least in the short run, if auto manufacturers are left to fail. But should we keep throwing good money after bad and keep subsidizing inefficient industries in a world that has significant excess capacity? Governments around the world, such as in Canada, the U.S., France and elsewhere have for years injected funds into their ailing car companies. The U.S. government, in particular, has rescued Chrysler at least twice the past 35 years.

Should we postpone the inevitable? This is because in the end, inefficient auto manufacturers, especially in developed countries, will see their business disappear and will either have to exit the industry or at best shrink and/or consolidate.

Car manufacturers struggle to differentiate themselves from each other. But differentiation that is easily duplicated by others, as is the case in the car business, adds nothing to value creation in the end. The product becomes commodity. Product differentiation and a strong brand are not the same as a profitable franchise. Mercedes Benz will testify to this.

To create value in the car business one has to be the most efficient producer — the one with the best operating efficiency and the best asset and financial management. Such things as buying the right assets and tracking their use, controlling costs, non-unionized labour, good relationships with employees and customers and ability to innovate and reinvent itself are key to efficiency.

Having the right capital structure, paying the right dividend and having good relationships with banks and shareholders are the icing on the cake.

Only a few car manufacturers fit the bill – Japanese companies, like Toyota and Honda. Despite significant progress made by other companies, the Japanese are still ahead in terms of efficient operations. The relentless push for efficiency is normal business for Japanese companies. Toyota, for example, has lowered the conveyor belt/assembly line in its new plant and that reduces the height of the plant and cuts heating and air-conditioning costs.

Over the last three years, cost of goods sold to sales and R&D to sales averaged 83.92% and 4.20% for the U.S. car manufacturers vs. 81.67% and 4.90% for the Japanese, respectively. Over the same period, sales grew by 4.68% for the U.S. car companies vs. 30.88% for the Japanese, while at the same time production declined for the Japanese and grew significantly for the U.S. companies. And average assembly time per vehicle is 21.23 hours for the Japanese car companies vs. 22.93 hours for the US companies. While a significant improvement from past experience, the U.S. still lags behind the Japanese.

As with commodity stocks, overcapacity is a killer for car companies – especially when the economy slows down. A lot of capacity has been built in countries such as Brazil, Russia and India. And China is expected to achieve annual exports of two million cars within two years, according to a KPMG’s 2014 automotive survey. Moreover, three quarters of the survey’s respondents also saw a very high likelihood of car manufacturing excess capacity in North America, Europe and Asia.

In the short run, the inefficient producers will stay in business, but in the long run prices will normally fall to the cost of the most efficient producer. At this time, the most inefficient producers will either go out of business or will be bought by others.

This is not just my opinion, it is a fundamental economic principle – competition has a corrosive influence on profits. Chrysler, General Motors, Fiat, Volvo and others are a living example of this.

But let me be clear. I am not talking about the Porsches of the world, as they are the cool cars with the cool style that people want to pay high prices for – bought mostly as status symbols. This creates a form of customer captivity: what Warren Buffett calls a moat that allows these car companies to remain profitable and create value for shareholders.

The rest of car manufacturers are simply commodity producers exposed to commodity producers’ weaknesses.