Time to Spread the Risk

Will automakers attract capital over the long run when they can't provide adequate rates of return?

Ah yes, wasn't this about the time when all those automakers were supposed to be raking in piles of profits? Remember how all those mergers and acquisitions were going to produce miraculous synergies? And remember how all those e-commerce ventures would cut costs and boost margins?

Well, guess what? It hasn't worked. Every car company in the world has watched its profit margins slump over the last five years. Most of them are bumping along at a measly 2.5% return on sales. Despite giving it all it's got, this industry is getting less profitable every year.

Imagine that you sit on the board of directors of one of these automakers. How could you in good faith recommend that the company invest hard-earned shareholders' money in a new vehicle program, when you know for a fact you could earn a better return with no risk whatsoever investing it in U.S. Treasury Bills?

Think about the long-term implications: Will automakers be able to attract capital over the long run when they can't provide adequate rates of return?

No one seems to be facing up to this fact. Instead, they're just doing more of what hasn't worked: squeezing suppliers for price cuts, slashing subsidies to dealers, and handing out pink slips to employees.

But they're not going to cost-cut their way out of this one. In fact, they're not going to improve quality enough, bring new products to market fast enough, or get lean enough. Just look at the best car companies in the world. Their margins stink. No matter how much energy is thrown at it, the current business model simply doesn't work.

So does the industry just swallow hard and say, “We're never going to make better returns than this. This is how it's always going to be, and we better get used to it,” or does it look for a new business model? I'm arguing for the latter.

This is an industry that consumes huge amounts of capital. New car programs typically cost around $2 billion. A new assembly plant these days runs around $800 million. An all-new engine costs $500 million. And the list goes on and on. If you happen to get it wrong and the public doesn't like your new car, you've just chewed through a staggering amount of shareholders' money with nothing to show for it. And even if you get it right, the returns, on average, are not very good.

That's why the merger and acquisition route looks so appealing. You buy another automaker, then share platforms and components. But this hasn't produced the optimistic synergies everyone expected. Even more telling is the fact that Toyota Motor Corp., which never jumped onto the merger and acquisition bandwagon, is probably the most profitable of the mass-market car companies right now.

What the automakers need to do is reduce the amount of money they invest by spreading that investment over the entire supply chain. Those who read this space regularly will think that I'm starting to sound like a broken record, but automakers should buy everything from suppliers. And I mean everything: body, chassis, powertrain, interior and electrical/electronic. They should even let suppliers do all the assembly of these components and the vehicles themselves.

Imagine the investment savings! If all an automaker had to do was design and develop the vehicle, manage the program and interface with the customer, it could literally come out with new cars and trucks for a fraction of what it costs today. Automakers could spend more time figuring what customers want and designing products to meet those needs, instead of worrying about how to cover the cost of their capital.

Yes, suppliers would have to bear the investment burden for their portion of the vehicle, but that would be reflected in their piece costs. And guess what? If a new car program turned out to be a dud, the automaker wouldn't have to bear the entire investment burden. The risk would be spread throughout the entire supply chain, all the way down the tiers.

Vertical integration was the 20^th century business model for the auto industry. Virtual integration is the business model for the 21^st. That's why the most important new car introduction at any auto show anywhere in the world this year was the Cunningham debut in Detroit. It's not that this car represents a breakthrough. But the virtual car company that will produce it may be one of the most important developments this industry has seen in a long time. Bill Li at Build-To-Order Inc. is on the same track.

These two efforts may crash and burn, and so shouldn't be used as the ultimate litmus tests of this business model. Automakers should be looking at how they can experiment with this concept, perhaps with a low-volume specialty model, or with a low-margin car in a developing country.

Outsourcing was a great boon to the auto industry during the 1990s. Automakers pushed huge investment costs off their books and suppliers grew exponentially. Now is the time to keep pushing more and more work down the supply chain. Concentrate on what is truly core, spread the investment risk, and reap the rewards.

John McElroy is editorial director of Blue Sky Productions and producer of “Autoline Detroit” and “American Driver” for WTVS-Channel 56, Detroit.