STATE OF THE AUTOMOTIVE INDUSTRY: STILL CYCLICAL AFTER ALL THESE YEARS

After more than twenty years of largely stable or growing sales, the years 2008-2009 served as an unpleasant reminder that the automotive industry is still very cyclical. In recent times, most automakers relied heavily on incentives to keep the U.S. sales volume in the range of 16-17 million a year (see Chart 1).

In 2008, the sales volume dropped to 13.1 million units as potential new car buyers were swept away during the second half of the year by the overwhelmingly bad news coming out of Wall Street and Washington. The market got even worse in 2009, with sales of approximately 10.1 million units in the U.S.

As sales dried up, vehicle inventories grew. In December 2008, the industry average swelled to nearly 110 days on hand (DOH), compared to a normal 50 to 65 days? worth of sales in the distribution pipeline. Some automakers like GM and Chrysler instituted complete shutdowns, while others resorted to line slowdowns, short work weeks, and other solutions. Light vehicle production in 2009 fell to about 8 million units, 40 percent below the volume of a year earlier.

Low vehicle sales and production translated to significant stress for dealers, automakers, and the supply base. The rapid industry decline set the stage for a drastic financial situation, leading to the dramatic Chapter 11 filings of Chrysler and GM and a number of their suppliers. An industry downturn had been expected as eventually inevitable, but the severity of the past year took everyone by surprise.

MACROECONOMIC FACTORS
The collapse of housing was clearly the primary culprit for the subsequent downturn in auto sales in 2009 (see Chart 2). With the collapse of the subprime mortgage market and its cascading effects, the auto industry was able to postpone, but not avoid, its own slide. New home construction is particularly important to pickup truck sales, and the pickup truck segment is 15-20 percent of the overall automotive market, so the impact of the bursting housing bubble was severe for this industry.

Recent news on economic indicators has been more positive, although we continue to see a wide range in forecasts from various experts. A recent Wall Street Journal survey of economists yielded estimates for 2010 real gross domestic product (RGDP) that ranged from negative 1.5 percent to a positive 4.7 percent! So much for ?consensus.?

Our interpretation is that nobody has a clue what next year will be like. We think a modest improvement in the first half, followed by stronger results in the second half, is a prudent expectation for the year. Home sales and new home construction have been increasing month-over-month, consumer confidence is trending upward, oil looks to be stable in the $70-80 per barrel range, and interest rates are low. Unemployment will continue to be the bane of the economy, acting as a drag on consumer spending, the housing recovery, and existing wages.

OUTLOOK FOR LIGHT VEHICLE SALES AND PRODUCTION
We expect 2009 to represent the bottom of the light vehicle industry cycle. U.S. sales declined 19 percent between 2007 and 2008 (from 16.1 million to 13.1 million units respectively), and another 23 percent between 2008 and 2009. From this low of 10.1 million units that we are estimating for U.S. sales in 2009, we are forecasting a 17 percent increase in 2010 to 11.8 million units (see Chart 3).

The Cash for Clunkers program was a significant stimulus for the industry, contributing an estimated 700,000 units to the sales figures for July-September 2009. Some observers fear that the program simply pulled sales ahead from 2010, but three factors support our view that it only resulted in a modest pull ahead of sales: 1) sales were negatively impacted from March-July as people waited to see if the Clunkers bill would pass; 2) over 50 percent of the Clunkers sales went to people who had never purchased a new vehicle before, so these sales came from used not new car sales; and 3) less than 30 percent of sales came from the Clunkers program (see Chart 4).

The vehicle production picture for the recent past and near future is illustrated in the chart showing quarterly figures (see Chart 5). We expect the first quarter of 2010 to remain basically flat with 2009 year end, although this will vary somewhat by manufacturer due to new program launches scheduled for the first half of the year. Our Autofutures® North American vehicle production forecast is calling for production of 11.05 million units for 2010, up 36 percent year over year.

One of the reasons that we are currently at the bullish end of the spectrum is the simple fact of replacement levels. The U.S. fleet is over 250 million vehicles on the road, with an average age of 8.6 years, according to the U.S. Department of Transportation. At a current scrappage rate of 5.5 percent, that equates to 13,750,000 vehicles sent to the salvage yard each year. While some of those vehicles may not be replaced, most analysts believe that a 10-11 million unit production rate is needed just to offset this natural shrinkage of the vehicle fleet.

We expect to see a gradual return to what could be considered ?normal? levels of 14-14.5 million over the next five years (see Chart 6). Over the long term, automotive sales should remain relatively robust. Demographic trends suggest that there will be an additional 25 million people of driving age in the U.S. by 2020, and it is clear that Americans still love cars.

The Obama administration?s focus on improving CAFE and emissions regulations will encourage automakers to seek creative solutions to both fuel economy and greenhouse gases. Product plans will reflect the commitment of greater resources for the development of smaller vehicles. Also, we will see a host of contributors to improved fuel economy, such as powertrain-related equipment and techniques, lightweight materials, electric vs. mechanical/hydraulic-powered systems, and so on.

In our view, the internal combustion engine (gas or diesel) will remain the dominant powertrain choice for the foreseeable future, i.e. 30-40 years. There are a number of prospective substitutes, the main variants being hybrids, bio-fuels, electric, and hydrogen fuel cells. The key is that electronics will be used as an enabling technology vs. a competitive one.

So, there will be some changes in vehicle mix to reflect the tastes and needs of different generations ? shifts between segments, new designs, new powertrains, etc. ? but overall sales should eventually recover. We are confident that the industry (automakers and suppliers) that emerges from the restructuring of 2009 will be capable of meeting those market requirements.

THE SUPPLIER INDUSTRY: A CLEAR ENVIRONMENT OF WINNERS AND LOSERS
It is said that the average vehicle is comprised of 30,000 individual parts, including 8-10,000 major ones. It has been a phenomenally difficult year for most suppliers, but we are starting to see a wide range of outcomes in supplier health. Our seventh biennial supplier survey in 2009 found strong evidence that the top-performing suppliers are separating themselves from the rest of the industry both in terms of top- and bottom-line performance.

Stronger suppliers are gradually improving their profitability in a number of ways, including gaining price relief from their customers for raw materials costs, resisting demands for pricedowns, and dramatically improving their cost structures.

Almost 60 percent of respondents in our survey said they successfully reduced their cost structure in 2009 by over 20 percent, with many claiming a 30-40 percent reduction. Measures included downsizings, plant consolidations, layoffs, and countless other steps. A surprising 50 percent of respondents expect at least 25-30 percent of these cost improvements to be permanent, even as production levels resume. As we get back to a more normal level of sales, the supplier industry should start to be profitable for the first time in over fifteen years.

Companies that went into the downturn with relatively low debt have been better able to withstand the credit crisis and will have an easier time with the capital required to support increased production. Access to capital (or the lack thereof) will clearly lead to some additional supplier liquidations but not anywhere near what many people have been predicting.

Some sources project that one-third to one-half of the North American supply base could disappear, but we do not expect that level of liquidation or consolidation. It is likely that there will be a smaller number of Tier Ones selling directly to the OEMs, but there will continue to be a large number of suppliers lower in the food chain, regardless of that consolidation at the top.

In the area of machinery and equipment, there is evidence of improving conditions. Domestic tooling suppliers are becoming more competitive and gaining back some of the footing lost to cheap foreign sources earlier in the decade. Some of the trends that we have observed in our consulting work include the following:

? Auto industry participants recognize the value of a domestic supply base;
? Domestic manufacturing costs have decreased;
? Shifting business models for tool makers have resulted in increased efficiency (manufacturing vs. craft model);
? Greater use of automation in manufacturing process
? Tool shops embracing lean concepts
? Tooling companies are increasing the level of sophistication and specializing in more niche technologies to create differentiation;
? Savvy tool makers are investing in more employee training and development to combat labor shortages and gaps in skills.

Opportunities for companies in these fields to improve their position include the following:
? Offer value-added services to customers as part of the overall package;

? Design assistance early in the program
? Process engineers to help improve customers manufacturing efficiency
? Work with customers to demonstrate the value of lifetime costs for tooling (early involvement, better information upfront etc.);
? Design tools for specified program life (save costs through eliminating design ?overkill?);
? Develop partnership-like arrangement with customers to retain the business long-term;
? Continue to increase process efficiency and lean concepts internally.

Overall, focused suppliers that have a commitment to lean thinking, strong program management, strategic financial management, and deep customer relationships should do well in this new environment. The key is to clearly define your strategic position and develop an organization capable of flawless execution. Given the changes in the external environment, we could argue that the next few years offer the best opportunity for suppliers to create sustainable profitability. Certainly a pleasant change from the last fifteen years.

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Kim Korth is president and owner of IRN, Inc., 2680 Walker Avenue NW, Suite A, Grand Rapids, MI 49544, 616-785-5175, Fax: 616-785-5163, www.irn-automcom . IRN is a consulting firm specializing in strategic advisory services, research, and automotive intelligence for middle-market manufacturers and the financial institutions that support them.