Tuesday, February 24, 2009

Quarterly Mega-Blog: Where Are We Headed? or The Winter of Our Discontent

“…yeah, we need to make sweeping budget and staffing cuts across the board, across every division. OK? Any questions? What about small car? I said every division. But the Small Car Platform is the only platform selling right now, really, should we cut here, too? Yes. It just wouldn’t be fair to the rest of the organization.” Executive staff meeting excerpt.

Great leadership or incredible insanity? We will get back to this.

Barack, the media, and just about everybody is doing a great job telling us how bad things are, … and are going to get. Belt-tightening is a nice way of saying slashing costs and firing people. It is difficult to think straight in this recession. Our industry does fairly irrational things with a sense of gold plated certainty (I am restraining myself from calling this “stupid”). The small cars segment was the big seller in 2008. Now we hear a lot about a 10-11MM unit year in 2009 (vs. 13MM and change in 2008, and plus 16MM in 2007.) I suspect our industry CEOs are fairly smart about what segments not to cut back on. For example, we will not see peanut butter production cuts that will hit small car the same as large car. Small car makes money (sometimes), large car loses money (now, all the time). Large car gets hacked, and small car survives much less damaged. This actually makes sense to me. I get it: cut things that don’t make money and don’t represent the brand as well, but protect the money makers and brand builders. Like Honda.

The birth of most vehicle ownerships starts with a miserable 45-minute sales process that resembles a C-section. The remainder of the ownership relationship is handled by the parts and service departments at dealers that are, in turn, serviced by the aftersales divisions of the OEMs. For car and light truck OEMs, most of 2008’s positive operating cash flow came from small car sales, and service-parts. Few rolled everything up and made a profit. Now “belt-tightening” and cost slashing is everywhere. Why do these brilliant CEOs have this gold-plated certainty that they should peanut butter service-parts with cuts (the only consistent profit center they have ever had) while nurturing small car (that they cursed in the 1980s and 1990s)? I don’t get it.

Maybe it’s just me. OK, no more rambling.

So, how is the market shaping up for 2009? Let’s take a peek at the seven industry segments we track: Agriculture, Construction Equipment, Heavy Truck, Independent Aftermarket, European cars & trucks, Asian cars & trucks, and Domestic cars & trucks. We developed a simple scorecard for this that has 21 motor vehicle industry companies grouped into 7 segments, and assigns each company to various “quintiles” for each of: (a) common stock price change during past year, (b) stock price change during past month, (c) parts sales change estimate for 2008 vs. 2007. We used stock price movements under the theory that the markets, dominated by big & smart institutional investors, are somewhat efficient. We ranked the 7 segments by simply averaging the available quintiles scores. As a benchmark, the Dow Jones Industrial Average would receive an average quintile score of 3.98, putting it in 6th place. This means that 5 of our industry segments outperformed the Dow. Our quintile scoring methodology is not perfect, but it tells a story that has some sense to it. You will notice that there are rows of filled in circles inside the boxes below. Each circle represents the results for one of the 21 unidentified companies in the sample.

#1: Heavy Truck tops our segment list, pulled all the way there by stock price movement. Given the beating this segment took last year, this was initially surprising. But, on close inspection, not really because of fairly strong segment “tailwinds.” Foremost among these tailwinds is the military replacement of Humvees with a long range Joint Vehicle Tactical (JLTV) program: Navistar, Force Protection, BAE Systems, and others are participating in the bidding process. Already deployed in Iraq are MRAPs (Mine Resistant Ambush Protected vehicles). These are heavy-duty “parts bin” vehicles. For example, Force Protection relies heavily on Mack truck components, and Navistar’s MRAP leverages their heavy truck components. The MRAPs have very different use profiles in the field vs. the Humvees. When an improvised explosive device (IED) hits a Humvee, it destroys it. In contrast, there are some MRAPs in Iraq that have over 1,000 IED hits and are still operational. It keeps troops alive and gets back in operation by dipping into the parts bin. Everybody in the military knows that 63% of all military deaths in Iraq have been caused by IEDs. Terrorists know what works; so does the military. So, even with action in Iraq quieting down, the IEDs made obsolete a lot of military hardware that must be replaced. Other good news? Diesel prices have been falling precipitously, and this might slow down the swing to intermodal from pure over-the-road truck – though some think just the opposite because of pricing and modal switching momentum. Also, 2010 emission standards will act to sell more trucks in 2009, though many industry insiders are skeptical that this will have much of an effect on sales in this recessionary economy. It is all about “the recession” – the average age of Class-8 vehicles on the road in 2009 will hit 6.4 years, leading one to believe that there is a real need for replacements … if buyer confidence returns. Finally there is the stimulus package; $53 billion in infrastructure projects will sell some trucks … very late in 2009. Counterbalancing these “tailwinds” are several “headwinds.” First off is the sheer drop in goods-flow due to lower recessionary consumption and manufacturing activity. Furthermore, the global credit crunch will take a bite out of Class-8 truck sales and force more dealers out of business. The market’s large institutional investors see all this, and have ravaged this segment less than the other 6 segments. The market sees the global military application and the need for massive replacements. It understands that selling parts to repair damaged vehicles is a lot more profitable than replacing destroyed vehicles (that have significant stockpiles back home). It understands that these same economics work on delayed purchases due to the lack of credit. The market understands that diesel prices trigger modal switching, and that US rail prices are already the lowest in the world (low cost and at fairly low levels of service). The “long shot” possibility is that Congress could roll out a wrapped-in-green “scrappage incentive” that could help motor vehicle sales in every segment. This might make more sense than some of the other bailout strategies. The market knows that the traditionally heavy cyclicality of this industry segment has made it scrappy and innovative. Innovative? Navistar just launched “PartSmart” – a separate private label “value line” of parts that costs up to 20% less than genuine. This is being “scrappy.” Looking at this all together leads me to believe that HT will stall on vehicle growth, but have an up-year in the sales of aftermarket parts – call it 2% - 4%. 2010 looks like a winner. That’s what the market sees.

#2: Ag comes in at #2 in the winter segment roundup. Most of 2008 was a good year for crop harvests and prices, and parts consumption. This is a segment that has had strong tail winds for the past several years, but now seems to be adrift. First, the tailwinds. A growing world population needs food, and this is good for farming. In terms of the big volume food crops, we like to think of total acres planted and harvested as an indicator for parts need. Planting and harvesting causes wear, and wear causes parts demand. Overall, 2008 was a very good year. However, recent food commodity price deflation has caused some concern in the stock market. With fairly recent declining prices to farmers, 2009 plantings and harvests could go down. This would mean declining whole-goods equipment purchases. The new-Washington is not as enamored with ethanol production from corn, because of the bad rap we get from the world food markets and from the economic suitability of this fuel substitute. As a result of this, and more, corn plantings and harvests were significantly down in 2008. The credit crisis will certainly take a bite out of whole goods sales on the high-end stuff. The strengthening dollar will make US exports of food and machinery less attractive. Golfing is down as a sport, and this will act to erode the high-end grounds care equipment over time. Recessionary cut-backs will act to contract the do-it-for-me lawn care market, but will increase the do-it-yourself market and boost the low-end of this machinery market. Overall, the whole goods side of this industry will inevitably contract in 2009. However, the parts market should look OK. I suspect the stock market reaction to this segment over the past month reflects all this – it sees 4Q 2008 commodity price deflation and the underlying econometrics, and is not happy. The big picture on this leads me to believe that parts sales will not top 2008 and will struggle to come in dead even to 2008 in 2009 (which was a wonderful year for Ag parts).

#3: European auto importers come in at #3 through consistent performance. The stock market is not as worried about these companies and there are no fears of bankruptcy. To be honest, year-ago European OE stock prices were absent the hype of the Asian OEMs and absent the gloom of the domestics. Outside of Volvo, the Europeans, as a group, did much better with vehicle sales than any other sub-group. European import parts sales were quite good in 2008 despite a harsh vehicle sales environment. Lower units in operation certainly helps here by limiting the field of IAM competition. But, that does not really explain what’s going on. These OEMs have protected their brands consistently over time and are focused on older-money market niches. So, the brand means something, and this “something” is consistently reinforced. The European importers seem to understand the ownership experience better than many other OEMs do, and have been investing here for a longer period of time. Telematics, service levels, service retention – you see more work in these areas than at other OEMs. So, what about 2009? The Europeans will continue to market service quality and build customer service loyalty. For vehicles, we will see some market erosion, but in parts we expect these OEMs to more than hold their own – 2009 vs. 2008 up 2% - 3%.

Fourth place is the #4 Independent Aftermarket (IAM) where we track 6 publicly traded companies. Their mid-pack performance is curious, since they do not have any of the same issues as the OEMs with declining, or jeopardized, whole goods sales. These companies are all about service-parts. Pep Boys had sales declines in 2008 (of 4.7%) vs. 2007, and the stock market punished them for this. The others experienced sales increases in the 2% - 3% range (or, had apples and oranges top lines like O’Reillys acquisition of CSK and LKQ’s acquisition of Keystone). Even with modest sales increases in 2008, the stock market likes LKQ and AutoZone. It sees LKQ aggressively going after the collision parts segment and increasing share through a “previously owned” genuine offering. This rough recessionary economy will bring LKQ even closer to the insurance companies due to obvious economic synergies. AutoZone is the dominant player in do-it-yourself (DIY) and has its gun sights focused on the do-it-for-me (DIFM) market. Zone is remarkably well run, while the perennially sick Pep Boys is vulnerable for further displacement. Also, there is the obvious Wal-Mart Effect recessionary trend of consumers moving to less expensive offerings, which means away from ill-perceived high cost dealers to ill-perceived low cost independent repair facilities. The overall mixed signals in stock market prices reflect a bunch of headwinds. Folks are driving less, even with much lower fuel prices – this is shrinking the market. Fewer miles means fewer repair incidences and fewer collisions. The collapse of the new vehicle market means that there is more dealer service bay capacity available and a greater focus on dealer fixed operations. So, what about 2009? This is an industry segment that is not terribly introspective. They think the OEM genuine purveyors are not terribly smart, and tend not to pay close attention to them. They like to hunt in their own backyards and are very sensitive to what the market thinks of them. They will stealthily take price in 2009 to get their top-line imperatives and show growth, but most of the action will be a feeding frenzy internal to this segment. Watch out for LKQ.
#5: Construction Equipment comes in 5th for all the reasons we hear about in the news every day. There are literally thousands of charts that can be used to show the “headwinds” moving against this segment: declining house prices, glut of housing inventory, tight borrowing, squeezed capital spending, huge job losses, China recession, low oil prices … the list goes on and on. The now-passed Obama stimulus bill has billions of dollars allocated to capital projects, but the stock market is not convinced that this will make much of a difference in whole goods sales in 2009as evidenced by Cat’s post inauguration stock prices. The global post-October 2008 banking meltdown hit very hard and all of a sudden. Commodity price/volume deflation tied to oil prices and/or the recession will negatively impact mining operations. And, the housing construction meltdown will adversely impact the small stuff. Pretty much all headwinds. Tailwinds? This segment will have to feed off the stimulus plan and compete with the plethora of highly mobile used equipment in the global markets. 2008 parts sales were generally up, but under much friendlier market conditions. How will 2009 shake out for service parts? My guess is that it will be difficult simply because machine hours will be significantly down across the board. This is a tough one. The 2009 focus in this sector will to become more competitive and efficient in things like labor productivity, inventory management, terms and conditions, more comprehensive and more economically compelling fleet management, selling 3PL services (Cat), and pricing.
#6: Asians mostly reflects stock price losses on the Tokyo stock exchange as giants are being slain by negative earnings. We had trouble with Hyundai’s stock prices, so we did not include them in this group – they would have improved this score a tad (the conference edition will correct this). To a certain extent the kingly Asian car companies had, for decades, busted the myth that the automobile industry was hopelessly cyclical, moving from boom to bust to boom. With Toyota’s announcement of its first operating loss, that king was pronounced dead, and the stock market reacted. The 3 million unit contraction of the 2008 auto market could not accommodate the year-over-year volume increases even after market share gains. Volume decreases coupled with significantly increased incentive spending added up to bad news. Parts sales stalled or did not meet plan. Honda and Subaru emerged as winners in this environment (and are not in my composite). What about 2009? There are some tailwinds - many of the Asians have issues with tight dealer service bay capacity and customer service satisfaction. The only other good news is the bad winter. Snow and icing conditions in the Northeast and Central states are much worse than in 2008, and this will result in increased demand for collision parts. But the headwinds are cyclonic. In the past, guys like David Halberstam and Tom Peters were linked with critiques that US companies are way too sensitive to quarterly financial results – look at Toyota and their long term strategic focus was a common sound-byte of business wisdom. Well, that king is dead too. Tokyo, welcome to Detroit! The Asians have been taking out their peanut butter spreaders and making budget cuts in their aftersales divisions. Typically “lean & mean fighting machine” budgets and overhead have become anemic where the prevailing focus is on operations, not reform and innovation. If the market is between 10 – 11 million units, 2009 will be worse, sales-wise, than 2008.

#7: Domestics come in last due to horrific stock prices and disappointing sales trends. You’d need a D9 Cat to sort through the bad news here. So, what’s the good news? The good news is a decade-long legacy of reform and improvement. For the past 10 years, Detroit has been the innovator in supply chain thinking, terms and conditions re-wiring, Telematics, organizational structure, supplier management, pricing, and IT development. Although the domestics have melted steadily over the past several years, they have held on to their brain trust and thought leaders. The bad news is that 2009 will be even more of a struggle than 2008. Down 2%.

What’s the point of all this? Lots:
  • For Heavy Truck, they’ve been down so long everything looks up to them. The survivors are efficient and scrappy. For decades they have been looking for new markets and fighting hard to participate in the worst possible market conditions. When Congress talks about what they want to see in industry evolution for Detroit, they say “Toyota”, but really mean “Navistar.”
  • Ag has seen a rather abrupt change in their tea leaves that will cause them to curtail investment and innovation. On August 30, 1960, to introduce the new tractors to all of its dealers in a single day, Deere chartered planes to fly more than 5,000 people to Dallas. The day would mark the release of a line of farm tractors that would soon evolve into the standard all other farm tractors would be measured by. The industry needs this again, but with more a focus on technology, and “market”. They can leverage experience from the Europeans and domestics.
  • The Europeans seem to be focused on brand building, share defense and capture, and step-by-step strategic improvement. Given the economics and service impacts of service-parts, this should be a no-brainer to everybody reading this blog.
  • Don’t worry too much about the IAM in 2009. They are die-hard cannibals and will be feasting on family flesh for most of the year. Except LKQ.
  • Construction equipment? There is a virtual crimson tide of recessionary cutbacks here that is inescapable. They need to be more heavy truck-like (scrappy), European (steady brand-building), and domestic (process re-engineering) to stay afloat in 2009-2010.

  • Asians? Re-read Halberstam and don’t follow Detroit’s lead in how to survive a bad quarter, half, or even year.
  • Domestics? Be nice to Obama.
By the way, where did last year's loss of two million annual new vehicle sales go? Used. (“Edmunds.com calculated that roughly 511,000 used-vehicle sales in the last three months would normally have been new sales if the economy was healthy … a seasonally adjusted annual rate of more than 2 million units, which would equate to over 15 percent of new-vehicle sales” AutoReMarketing.com, Consumers Changing Focus from New to Used, February 19, 2009). Unfortunately, used buyers are exponentially less loyal to dealers for maintenance and repairs. You guys have never made much of an effort to capture this service business, but somebody is going to figure out how to do this. You can’t do this with a peanut butter spreader, sharing the pain, or being “fair.” That’s not great leadership; it’s being incredibly insane.

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