Wednesday, May 6, 2009

Chrysler Bankruptcy and What It Means for Us

At this year’s NASPC we were asked by a number of participants what the impacts would be of GM’s plant closings and Chrysler’s bankruptcy. Depressing questions. Even more depressing when viewed from the perspective of the blood, sweat and tears expended by GM and Chrysler staffs in improving their operations. Looking at the top 10 most improved parts warehouse operations based on 2008 metrics, GM and Chrysler occupied 9 slots. Chrysler walked away with the single most improved warehouse. I am humbled by all this accomplishment.

Do you remember that great scene from Good Will Hunting where Matt Damon is interviewing with the CIA and he is asked why he shouldn’t go to work breaking codes for the CIA? He launches into a chillingly plausible description of the chain of events resulting from successfully breaking a code, leading to a raid on a militant camp somewhere -- eventually leading to his buddy in South Boston being unemployed. This is a perfect example of system dynamics – the study of how almost any environment can be described as a set of complex systems, with many interrelated components that all ultimately impact each other via feedback loops.

That system dynamics thinking is a perfect application for what is happening in the auto industry today. My concern is that the Obama Task Force either has not had time, or does not have the insight, to really see ALL of the effects (not just first order, but second and third order) of their efforts to turn the dials to restructure the auto industry and rebuild our economy.

Due to the unquestioningly negative opinion that so much of the general public has of the old Big-3 – fueled by the generally uninformed media – most of the task force was pulled from very well educated outsiders, bankers, or consultants. For them, Chrysler and GM are approached as text book case studies, and the architects are the best and brightest that America’s B-schools have to offer. Hey, there’s no way that the automotive industry can be any more complicated than a credit default swap. Simplicity is the answer. I grew up on a farm, and I’ve heard that before. For example, growing beans is simple. As long as it is the right kind of simplicity. Getting there, can be pretty complex.

Let’s lay just a little foundation before we take a system dynamics approach to understanding the first, second, and third order effects of Chrysler’s bankruptcy – in particular the effects of that bankruptcy on the service-parts supply chain. While there may have been issues on the vehicle side, on the service-parts side, Detroit was not stupid, they really were listening and doing over the past 20 years – learning, improving efficiency, and cutting costs. Let’s just focus on costs. The answer to lower costs in the service-parts supply chain was to adopt Lean – Toyota showed us the way here. Lean goes way beyond manufacturing; it encompasses the entire enterprise. We found that we can reduce fixed and variable costs by streamlining our supply chains, reducing variability, and adopting sell-one-buy-one – smaller more predictable shipments, made with small batch manufacturing, shipped in fast milk-run delivery systems, received with tiny receiving docks, put away in tiny bins, picked in small line quantities throughout the day, and shipped to customers in just-in-time fashion. Billions of dollars of inventory was expunged from the enterprise, and it all works fine. Usually. The American version of “Lean” went further than Toyota did. It linked in aggressive purchasing methods that squeezed all the fat out of supplier contracts – and possibly even some muscle. Even during times of inflation, suppliers were required to show year-over-year net cost reductions. This “squeeze” worked its way through the extended supplier enterprise – with nips and tucks at every major cost center. Competition increased and cost cutting continued beyond Lean and into the just-plain-Mean. We have seen years of annual reductions in force and conversion of in-house staffs to contract services. A lot was outsourced - way beyond IT. Don’t get me wrong – lean is the answer, and under most conditions, works great. But it doesn’t provide much of a safety net when massive external factors change the game.

First Order Effects: Ok, Chrysler declared bankruptcy last week. How does this affect all the other companies that play in this space? On the day of the filing we saw the beginning of what system dynamicists would term first order effects. They announced a shutdown of pretty much all of their assembly plants for what could be a multi-month period of time while they make their way through the bankruptcy court. This makes sense because automobile sales are down by around 40% and there is a glut of inventory at the dealers. One very large point: this announcement was made within a week of GM’s very significant shutdown announcement. What will the impacted suppliers do? The largest ones are protected by the Obama supplier “TARP” ($5 billion) and many others will go to the front of the line in bankruptcy court to collect their receivables. The mid-tier and smaller suppliers will be treated like any other creditor and, inevitably get cents on the dollar.
  • It is reasonable to expect that the loss of cash flow from the GM and Chrysler shutdowns will push some suppliers over the brink and they will seek bankruptcy protection. This will happen to big, medium, and small suppliers.
  • Tools will be idled, held-up, or lost. OEMs will need manpower to get these tools back from bankrupt suppliers. How much of that manpower has been RIF’d away?
  • Once they get the tools, they will have to re-source the production with limited staff (that may have been outsourced) to healthier suppliers who will now have “dream” leverage in terms of costs and terms – putting even greater pressure on weaker suppliers.
  • The “outsourced” staffs at the OEMs, who need to do the work of managing tools and purchasing contracts, belong to service and manpower suppliers who are not protected by Obama’s TARP, and will not be promoted to the top of the list of “creditors.” Many of these will be hurt and go away. So the OEs have outsourced manpower, and many of those suppliers are going away. Now where do the people come from?
  • So what happens to the supply of service-parts? Most suppliers already think that service-parts production is a thankless burden that they would prefer not to have. But they are compelled to produce service-parts by agreements for production parts that require it. Now it gets interesting. If those production parts agreements become questionable during bankruptcy proceedings, will those suppliers also simply stop producing parts for service use as they shut down their production plants to mirror what is happening at Chrysler and GM production facilities?
  • Many will try to continue to service non-GM/Chrysler accounts. The problem is that the production and distribution economics are all tied together. Supply may become sporadic and quality may degrade. The best case scenario is that the service we can provide dealers will be degraded. The worst case is that some (many?) genuine parts will simply not be available at a reasonable cost.
  • On the service-parts side, it’s already been announced that about $100 million of Chrysler’s short term financing will come from selling off inventory at Mopar, with consequences for supplier orders as well as parts availability.

Second Order Effects: The above First Order Effects (FOE) are child’s play compared to the Second Order Effects (SOE). The FOE is like a bad sunburn. The SOE are the resulting melanoma, where the danger of metastasis is directly correlated with the length of time that Chrysler is in bankruptcy. Here’s the tip-of-the-tip of the iceberg.
  • Chrysler’s sales will continue to plummet during bankruptcy as their brand images sour and customer confidence in their products erodes even further.
  • This leads to snowballing of already increasing dealership bankruptcies. Yes, GM, Chrysler, and Ford all needed to reduce dealer count, but they needed to do it surgically – this process will not be surgical.
  • Reduced dealer counts will further reduce ability to retain service customers – dealers will be further apart (less convenient), and customers will be even less confident in the viability of dealer service and OE warranty coverage (Obama’s pledge that the federal government will back OE warranties notwithstanding).
  • That service retention loss will put more dealers in financial danger, reducing both service revenue and further eroding vehicle repurchase loyalty – this is a classic death spiral for dealers.
  • Outsourced and contract services that are used to run the operations, interface with dealers, and fix problematical IT will degrade as these business arrangements become nebulous, and these suppliers become extinct. Replacing them needs effort, and this effort needs people. Where will all this come from?
  • More jobs will be lost from the extended enterprise – and the rate of job losses will be proportional to the length of time that Chrysler is in bankruptcy.
  • Job losses, Dow-doldrums/depressions, and sensationalist headlines will cause consumer confidence to drop. Again.
  • We will remain longer in the Keynesian Paradox of Thrift. All related sectors will remain in the penalty box longer.

Third Order Effects: Since these are at the bottom of the deck, they are already unrecognized casualties of war. But longer term, these third order effects could have the greatest impact on what the industry looks like when we eventually come out of this mess.
  • The vehicle service business will shift substantially.
  • The AAIA has been pushing the pro-aftermarket legislation with incompetent, but good-enough, research. They succeeded. Three Democrat representatives birthed HR 2057 recently – the Motor Vehicle Right-to-Repair Act. Recession troubles have gutted OEM lobbying budgets and, now that GM and Chrysler are controlled by the government, this sort of spending is frowned upon. It is hard to believe that the industry can field any sort of meaningful resistance to this bill. So, look to see increased aftermarket competition as a 3rd order effect that will take a bite out of 2010 and beyond.
  • Take this to the logical conclusion and perhaps the independent aftermarket takes a real run at trying to provide warranty service for OEs. By taking on the role of guaranteeing vehicle warranties, the Federal government may be opening the door for this (even if they don’t realize it yet). This further hits dealer viability.
  • It gets worse, at least for the Detroit companies. Service technicians have been a constrained resource for years. As Chrysler, GM (and Ford) dealerships go out of business this constraint will be less binding – but worse, as the best technicians move from Dodge and Chevy to Toyota and Honda, the Detroit companies' ability to compete degrades further.
  • But of course, some of those excess technicians will go to the aftermarket. This will improve the quality of aftermarket repairs and drive up the demand for genuine parts and genuine diagnostics and tools in the aftermarket. If an OE is set up to serve this wholesale market, this could actually be an opportunity.
  • With gutted staffs, clawing out of the recession with growth programs will be difficult. IT budgets are being slashed, field organizations are being pared down, and contract staff is being released. This will again accelerate the market dualities that exist between stronger and weaker OEMs, and between well funded aftermarket aggressiveness and the normally placid, now emasculated, OEMs. Again, 3rd order impacts in 2010 and the out years.

So, What Do You Do? The Crystal Ball future state does not look very good unless Chrysler emerges from bankruptcy very very soon. If you are not Chrysler or GM, what should you do?
  1. Understand your non-parts vulnerabilities – identify and talk with service suppliers who get the lion’s share of their revenues from Chrysler and GM (packaging, engineering, call centers, transportation carriers, dealer trainers, survey staff, 3PLs, HR, agencies, marketing services, IT services, etc.)
  2. Understand your vulnerabilities with your dealer customers – most vulnerable will be dualed dealers and dealer groups that are heavily invested in Chrysler and GM.
  3. Understand where you are most vulnerable in terms of parts: (a) current model production, (b) smaller production runs, (c) at bigger supplier plants that also supply GM and Chrysler.
    • Run, don’t walk, to your fastest moving parts suppliers that are also Chrysler and GM suppliers and ask them what they are going to do.
    • Do contingency planning - plan for the worst case from your most vulnerable suppliers.
    • I hate to say this, but stock up on aftersales parts from your most vulnerable suppliers and try to figure where to stock them (yes, violate all the laws of lean in the process).
    • Understand where you are in key parts inventories with your dealers, on a global basis, and think of contingency terms that will encourage more D2D and discourage hoarding.
    • And as a possible long-shot, think about whether this might be the right time to “in-source.” Are their key suppliers out there that are distressed, but might offer a good long-term investment for OEs that have the necessary cash, access to capabilities, and, most importantly, the right competencies to run them effectively long term?

But system dynamics works both ways – the down often keeps going down, but the up can keep going up. You just have to hang on and get to the potential upside to all of this. Can you see the following happening? Around 2012 or 2013 (or so), household income and wealth will return to trend levels. So vehicle demand could return to 16 or 17 M units a year because the real price of cars will continue to fall and the US population will continue to grow. By this time, roughly 1 M to 2 M units of production capacity will have been rationalized. Meaning that demand will be high, and supply reduced. Meaning that the automotive OEMs left standing will print money in the US market! How do you like them apples?

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