Caution: Rough Road Ahead

Most of the automotive news these days concentrates on the perilous future of America's Big 3 — General Motors, Ford and Chrysler. Yet the U.S. automotive industry is more than three firms. There are at least a dozen global automakers fighting for a share of a mature auto market with hundreds of different models. Even the most optimistic among us admit this is unsustainable, that the industry should expect a rough road ahead.

We read about it every day—the market for automobiles in the United States has all but evaporated. Last summer's oil spike initiated the sales decline, which was then exacerbated by the global financial crisis. The result is most clearly visible in the United States, where this April, 34 percent fewer vehicles were sold compared to the same month a year earlier.

This drop in auto sales, while particularly severe, is not unprecedented. Before and during the recessions of the mid-1970s, early 1980s and early 1990s, auto sales plummeted from their peaks at similar rates—24 percent, 32 percent and 20 percent, respectively—before rebounding within a few years along with the economy. We estimate that the current recession will see the market drop 40 percent from its 2005 peak.

Using history as an indicator, we believe the U.S. auto industry should rebound as it has before, but perhaps not so smoothly. The problems are manifold and structural. The U.S. automotive market is saturated —too many models, too many options, too many players and not enough buyers. In our 13th annual Townsend Study of the U.S. auto industry, released in May, we find that even with the most optimistic outlook for auto sales, industry restructuring and consolidation are inescapable.

Back to the Future

Figure 1: All industries follow a merger endgames curve

All industries inevitably follow what we call the merger endgames curve, which posits that all global industries consolidate through four stages: opening, scale, focus and balance (see figure 1). The U.S. automotive industry is not a stranger to this process. In fact, from buggy to hybrid, hundreds of automakers have come and gone. Remember Checker Motors, maker of the famed taxicab? Or Hudson, whose Hornet set auto-racing records in the 1950s? These carmakers, and many others, simply could not sell enough cars to survive independently. Checker died out after 60 years, its remnant company now a GM supplier that filed for bankruptcy in April. Hudson merged into American Motors, whose vestiges are now a part of Chrysler.

Auto-industry consolidation reached the balance stage in the 1970s, when GM, Ford and Chrysler owned 80 percent of the market. When regional market barriers fell during the 1980s, the U.S. automakers felt the full impact of a globalizing automotive industry. New entrants upset the equilibrium that had been established after decades of regional consolidation, effectively putting the industry on a new merger endgames curve, only at an earlier stage (the focus stage) that reflected the global changes.

Just as Checker cabs and Hudson Hornets are museum pieces now, it is fair to assume—albeit painful to say—that some of today's brands will become relics. For some, survival will depend on merging with other companies, such as Chrysler's planned partnership with Fiat. This has happened throughout history.

Just as Checker Cabs and Hudson Hornets are museum pieces, it is fair to assume—albeit painful to say—that some of today's brands will become relics.

In fact, most of GM's famed brands, including Cadillac, Pontiac and its European Opel division, were once independent companies.

Other automakers must downsize, cutting the number of brands and "nameplates" they offer—perhaps remaining in the market only as niche players (see sidebar: Too Much of Everything). A few will exit altogether, like Peugeot in the 1990s and Isuzu in 2008. The U.S. market could not support them, so they pulled up stakes.

The Rule of Three

This brings us to the Rule of Three, which states that almost all industries mature to a point where three full-line generalists—companies that compete along a broad range of products and services—hold between 70 and 90 percent of the market.¹ This rule is exemplified in the soft-drink market. Three companies, Coca-Cola, PepsiCo and Dr Pepper Snapple, now own more than 89 percent of U.S. sales as volume-driven, full-line generalists—in this case everything from cola to juice to bottled water. The rest, including Red Bull and Jones Soda, are margin-driven specialists that concentrate on specific products or customer segments.

Figure 2: The Rule of Three (1970s versus 2000s)

By plotting financial performance against market share in a particular industry, it has been shown empirically that companies in the "ditch"—without enough volume or high enough operating margins—will probably not survive. In the 1970s, the U.S. market reached equilibrium and the Rule of Three applied. American Motors fell near the ditch and was sold to Renault and later to Chrysler (see figure 2). Chrysler almost fell into the ditch but was rescued by a loan from the U.S. government. Around that time, several Japanese manufacturers entered the U.S. market as specialists, designing reliable, fuel-efficient small cars.

Fast-forward to the 2000s, and we find a crowded U.S. auto market. Alongside Detroit-based GM, Ford and Chrysler, the transplants Honda, Toyota, Nissan and Hyundai are operating as or aspiring to be full-line generalists. Operating margins of the top six manufacturers do not follow the typical pattern as suggested by the Rule of Three. When vehicle volumes collapsed in 2008, the weakest manufacturers fell into the ditch, as shown in the bottom diagram of figure 2. Thus far they have been saved from collapse by the U.S. government.

Looking ahead, we expect the market to become more competitive, as new entrants aim to make a dent in this crowded market. If competitive market forces are allowed to play out, the industry will consolidate. Some full-line generalists will merge, some will reposition as specialists, and some will exit altogether. In the endgame, we expect three full-line generalists to dominate the industry.

Too Much of Everything

The U.S. market is flooded with options. In 2008, there were 75 different sport-utility vehicle models, 22 pickup trucks, 42 crossover vehicles and 72 luxury cars available.² Overall there were 46 brands and 321 different models, or "nameplates" which is nearly triple the number of the 1970s. In that decade, the auto companies sold an average of 100,000 vehicles per nameplate; in 2008 they sold fewer than half that number (about 41,000 vehicles per nameplate).

Figure: Reducing namplates is crucial to survival

The trouble with so many nameplates is that each one carries incremental costs—for design, engineering, material, procurement and manufacturing, coupled with marketing, advertising and labor costs to support and sell the brands. Based on a statistical analysis of the top six U.S. auto manufacturers, which represent roughly 85 percent of the industry's total volume, we estimate the addition of one nameplate increases annual operating costs by an average of $300 million.

Combining this figure with projected sales volumes and nameplates, we can estimate average operating margins. This year, if manufacturers sell 10 million vehicles, operating margins will average negative 14 percent, the result of a sudden downturn in sales. Put another way, for manufacturers to earn an average operating margin of 5 percent this year, the number of nameplates would need to be reduced from 321 to 214.

Even with GM's planned elimination of Hummer, Saab, Saturn and Pontiac, there will be too many nameplates for all the full-line generalists, or mass-market players, to earn a sustainable operating margin (see figure). Moreover, the possible entry of electric car manufacturers such as Tesla or Fisker, or Chinese manufacturers such as BYD or Chery, will further crowd the picture. Because vehicles have longer product-development cycles—a vehicle today may have been designed three years ago—carmakers may find it that much more difficult to cull their offerings and balance supply with ever-changing consumer demand, especially if there are unstable fuel prices.

Wrestling with Wildcards

As history shows—and current conditions seem to dictate—consolidation is inevitable for the automotive industry in the United States. However, we see three "wildcards" that could upset the natural course of consolidation:

Government intervention. No one knows the extent to which the U.S. government will continue to intervene. It has already loaned billions of dollars to GM and Chrysler, money it will undoubtedly seek to recoup in the future. By propping up a firm that would otherwise fail, the government has the capacity to alter the course of industry consolidation. Indeed, "you break it, you own it" might be the mantra over the next few years for a government-owned auto industry. To ensure a return on its loans, the government will likely become a major stockholder of an automaker. If this happens, failure will be politically impossible, and consolidation much trickier.

During the height of the spike in fuel prices last year, buyers abandoned their large SUVs for gasoline-electric hybrids. When prices came down, hybrid sales collapsed.

Employee ownership. Employees taking significant ownership stakes in some automakers will be less amenable to downsizing or selling off pieces of the company. Unionized employees will want to protect jobs.

Consumer tastes. Drivers can take responsibility for some of the current upheaval, as sustainability awareness and high fuel prices caused many buyers to shun SUVs in favor of more fuel-efficient vehicles. Major market changes like this could allow a smaller player to gain market share and upset the course of consolidation. If fuel prices remain low, however, consumers might again opt for larger vehicles when the economy rebounds.

During the height of the spike in fuel prices last year, for example, buyers abandoned their large SUVs for gasoline-electric hybrids. When prices came down, hybrid sales collapsed.

In addition to regulating more fuel-efficient vehicles, it might be necessary to regulate fuel prices to avoid the seesaw effect on demand that makes it difficult for auto manufacturers to plan their portfolios. If fuel remains cheap and buyers remain enamored with bigger vehicles, there could be a disconnect between production volumes and consumer tastes.

When Buyers Start Buying Again

Dreadful economic conditions have been difficult for the auto industry, as people have postponed buying cars. When the economy rebounds, however, they will start buying again—and rapidly. Based on our study, we expect pent-up demand for cars to total more than 13 million by the end of 2009; 65 percent of the pent-up demand or 8.4 million vehicles will be "released" when the economy recovers. Barring any major policy changes—such as a "cash for clunkers" program that pays car owners to scrap aging vehicles—we estimate 10 million cars will be sold in 2009, compared to 13.2 million in 2008. For the years 2010 to 2014, we have devised three scenarios, based on forecasts of four macroeconomic factors—real gross domestic product (GDP) growth, consumer confidence, consumer price index and TED spread.³

Figure 3: U.S. vehicle sales will rebound after hitting bottom in 2009

Blue-chip. This is our best-case scenario: The economy rebounds more rapidly than expected and people start buying cars again. Sixteen million cars are sold in 2011, and by 2012, cars are selling above pre-recession levels.

Baseline. This is the most probable scenario: a gradual economic recovery through 2011, slowed by the side effects of fiscal spending. In 2010, 12 million cars are sold, followed by 13.9 million the next year and 16.1 million in 2012 (see figure 3).

Stress-test. In this worst-case scenario, macroeconomic conditions do not improve as expected, and people continue to postpone nonessential purchases. Auto sales bounce back slowly, without any pent-up demand, as aging vehicles must be replaced. Sales go from 11.4 million in 2010 to 12.9 million by 2012, but do not exceed 14.6 million through 2014.

Resuming the Love Affair

The auto industry of the future will look much different from the splintered one of today. With fewer manufacturers, fewer brands and fewer nameplates, the industry will reflect a leaner structure upon which to build. We have no doubt that the process of change will continue to be painful, especially for the stakeholders in companies that will merge, downsize or exit. But the industry has survived upheaval before—through the paralysis of the Great Depression, the stoppage of production during World War II, and the booms and busts of the past three decades. Americans need cars to get around, and when bad times end, they are ready to resume their love affair with one of their country's iconic industries.

Consulting Authors

DAN CHENG is a partner in the Southfield office and head of the North American automotive practice.

VlJAY NATARAJAN is a principal in the Southfield office.

GANG XU is a principal in the Southfield office.

MATT CHENG is a consultant in the Southfield office.

For more information, contact the authors.

¹ Rule of Three is a theory by Ivey School of Business researchers Jagdish Sheth and Rajendra Sisodia. It was outlined in their 2002 book, The Rule of Three: Surviving and Thriving in Competitive Markets.

² A crossover vehicle is built on the platform of a passenger vehicle but features many of the characteristics of an SUV.

³ “TED spread” is the treasuries over eurodollars spread, representing the difference between the rate for a three-month U.S. Treasury bill and the three-mymonth London Interbank Offered Rate (LIBOR). It is used as an indicator of the ease of credit availability.