

A Treacherous Road for Auto Investors

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THE FATE OF THE BIG THREE U.S. AUTO COMPANIES REMAINS uncertain as the credit crunch deals another blow to a troubled industry, and General Motors reportedly seeks a merger with Chrysler. To discuss this and the prospects of other auto makers and suppliers around the globe, Barron's spoke last week with John Casesa, a managing partner of the Casesa Shapiro Group. The New York consulting firm advises clients on mergers, acquisitions and other deals. Casesa, 46, who co-founded the firm in 2006, began his career in the mid-1980s at GM, where he worked in marketing and product planning, and then went on to become a sell-side analyst for 17 years, seven of them at Merrill Lynch.

"There is no traffic. It's not that people are coming into showrooms and can't get financed. Right now, people aren't coming in. Our next concern: When they come back, can they get financing?" – John Casesa

Chris Casaburi for Barron's

Barron's: Would it make sense for General Motors [ticker: GM] to make a deal with Chrysler, in which the private equity firm Cerberus holds a majority stake?

Casesa: A deal like GM and Chrysler looks terrific on paper. The combined entity would eliminate a great deal of assembly capacity and overhead, including central office staffs. It would also eliminate overlapping R&D and capital spending. So the great savings, in theory, could be paid for with Chrysler's cash. GM could essentially acquire Chrysler to close it down, which would have the added benefit of eliminating a competitor in the U.S. market. However, in general the track record of these automotive mergers is very poor, and this one could be particularly difficult because both GM and Chrysler are losing market share.

The combined entity would have 11 brands. And this Gordian knot of dealerships and brands, which has been so challenging for GM to untangle, would only become more so. So this is a deal that would be difficult to execute operationally, although it could happen because the motivations are so strong on both sides.


It is hard to see easy exit options for Cerberus with Chrysler, and it is hard to see any sort of sweeping strategic options that will improve General Motors' competitive position.

Wouldn't downsizing be hard to do, given all of the union contracts in place?

They would have to get rid of tens of thousands of people, both hourly and salaried, and that would require enormous severance payments. On the other hand, that is what part of the cash balances of the combined company would be used for. So while painful, that is the easy part. The hard part is putting together the product and the production systems and trimming the dealer network and the brand portfolio to a manageable size. It's easier to achieve synergy on the expense line than on the revenue line. You can figure out how many people to take out, how many plants to consolidate, and how to streamline the business, but there is a great deal of uncertainty around the revenue line. Just because GM has 22% share and Chrysler has 11% doesn't mean the combined entity will have anywhere near a 33% share.

What do you think of GM's prospects? The stock has gone from north of 40 a year ago to six and change.

All of Detroit's prospects have diminished in the past month. The selling rate has declined rapidly, even though gasoline prices are down, and the mix hasn't shifted back in any meaningful way to big vehicles. Consumer confidence has kept people out of the showrooms, and now there is justifiable concern about the ability to finance customers and dealer inventories. So the outlook has dimmed for all three companies. The longer the credit markets remain frozen, the more damage will be done to businesses and consumers -- and the longer it will take for the auto industry to see a rebound in demand. The financial markets and stock prices will probably recover far sooner than the demand for automobiles.

Is the crux of this problem that people aren't going into the showrooms?

Yes. There is no traffic. It's not that people are coming in and can't get financed. Right now, people aren't coming in. Our next concern is when they start to come back, can they get financing? We know that will be more difficult. I am hopeful, though, that if the credit markets unfreeze, some of the independent lenders will be back.

How is the credit crunch manifesting itself in the auto industry?

It has impacted the auto companies on three levels. First, they cannot access capital to continue to restructure. And restructuring includes paying to retool plants and to pay severance. Unless they can do those things, they can't be competitive. The second impact is that it is getting more difficult to finance dealer inventories. If dealers can't get financing to sell their products, they can't stay in business. So the number of dealers closing is accelerating. Third, it is getting more difficult to finance customers at retail. If people can't get a car loan, they can't buy a car.

So, you're pretty cautious about investing in the auto industry?

It is a time to be extremely cautious, because except for the companies with the best balance sheets and liquidity, the risks are very high that they won't survive this downturn. That is true for auto companies as well as suppliers; demand is falling to a level lower than the bottom of the last cycle, in 1991. And in 1991, this was a smaller country with fewer people. So adjusted for size, this is the worst environment we've seen in 50 years. As an investor, notwithstanding all the bad news we've endured, there is still considerable risk out there, particularly for shareholders who, in the case of many of these companies, face the prospect of Chapter 11.

What do you make of Kirk Kerkorian's decision last week to sell his stake in Ford [F]?

He's not one to give up easily. The sale is alarming.

What is your read on Ford, whose shares fetch about $2?

Ford and GM have a lot of the same characteristics. They are dependent on North America and on larger vehicles, and they have the same kinds of labor issues. But Ford does have the advantage of a much simpler structure. Ford added lots of brands by acquisition in the past 15 years, and it has been able to streamline its brand portfolio through divestitures. So Jaguar and Land Rover and Aston Martin are gone, Volvo is likely to go, and Ford's 33.4% stake in Mazda Motor [7261.Japan] will go. In a relatively short period, I think Ford can get down to Ford and Lincoln-Mercury. And because of their dealership infrastructure, they can really wind up being one channel, where the same store sells Ford, Lincoln and Mercury -- if Mercury survives. So Ford has an advantage in having a much simpler brand portfolio than GM does.

Another advantage is that it still owns 100% of its captive finance company. It may not be able to hold on to that if credit conditions get worse. But if the company can get through this, that will be a huge competitive advantage. The main question for Ford is that if GM or Chrysler winds up in Chapter 11, will Ford be able to avoid that same fate? And if you look at airlines, railroads, textiles and the history of the steel industry, it probably won't. If one of the auto makers goes, they will all go.

Suppose that scenario unfolds. Or even if one of the Big Three files for bankruptcy protection. Is that the end of the U.S. auto industry?

You will have a rapidly downsized industry, but one that will emerge to be competitive. Unlike years ago, the issue with the U.S. companies is not that they can't make a good car. Product quality is good now; technology is competitive. It is just that their business model, particularly the number of brands and dealerships, their labor relationship and their regional structure that is very North American-based, is out of date. And through an aggressive restructuring, which I hope would take place out of court, rather than in court, those things can be fixed. I can foresee GM, Ford and Chrysler coming out as companies with fewer brands, though still having a substantial position in North America, and being quite competitive.

Turning to the overseas car makers, how do things look for Honda [HMC] and Toyota [TM]? Although their stocks have been hit, they've held up better than their U.S. counterparts.

Honda and Toyota remain in a very advantageous position. Honda looks particularly good because it has almost no exposure to the traditional light-truck business like Toyota does. And Honda has remained very competitive in existing internal-combustion engine technology and every form of emerging alternative propulsion. Honda has a strong fuel-cell research program, a very strong hybrid program and a very strong electric program. It can even make diesel engines. So whichever way the world goes, this company is positioned to take advantage of that growth.

Also, Honda has a global infrastructure and an excellent balance sheet, and it is probably the best-positioned auto company in the world right now.

So Honda's at the top, followed by Toyota?

Yes, Toyota has everything Honda has, but it has bigger exposure to North America and some exposure to the light-truck business, notably pickups. But it's a small percentage of total sales. So I would only distinguish Honda incrementally, because it doesn't have a pickup-truck business. But they are both in great shape, with almost debt-free balance sheets, very balanced global footprints and extremely strong R&D.

Burdensome Costs: Like GM, Ford has a huge debt load, putting it at a disadvantage against overseas competitors like Honda.

What about the European car makers?

The Europeans are better-positioned than the U.S. companies are, but they are not as well-positioned as the Asians. That's because the Europeans still are largely regional companies, not global companies, and they are still very dependent on exports from Europe, which has been difficult with exchange. Except for Daimler [DAI] and BMW [BMW.Germany], which have built fantastic global franchises, even the big companies like Volkswagen [VLKAY] don't do nearly as well outside Europe as they do inside Europe, whereas the Japanese companies have become very successful in markets outside Japan.

There are a couple of companies that are well positioned to benefit from higher gas prices and the move to small cars, such as Peugeot [PEUGY], Fiat [FIATY] and Renault [RNSDF]. They have great engine and diesel technology, but they need distribution. And they need to build their brand names overseas. For those reasons, they are potentially interesting partners for the GMs, Fords and Chryslers of the world. But they are reluctant to take operating risk now to buy or partner with one of these companies.

What about the suppliers? Are any of them holding up better than the others?

It is the companies with the best balance sheets. Magna International [MGA], a Canadian company with a fairly diversified book of customers -- and good organic growth from new product introductions -- can withstand this [downturn] because it has virtually no debt. Another very interesting company is BorgWarner [BWA], which has a very conservative balance sheet. All of its products are designed to make cars cleaner or more fuel-efficient.

Do any other suppliers look interesting?

Johnson Controls [JCI] has a very diversified business. It is not only in autos. It is also in building control systems, and it has a rapidly growing battery business. It is pretty clear that the car will be electrified. The time line is not so clear, but the car will be electrified, and you will need batteries to do that. Johnson has a very strong position in batteries for hybrid vehicles.

Another company is Genuine Parts [GPC], which is a really unique situation. It is a parts wholesaler, selling to the "do it for me" market, namely mechanics. NAPA Auto Parts is the brand that they are famous for; they have about 6,000 NAPA stores in the U.S. Genuine's business is driven by the total number of cars on the road. It has paid a dividend every year since it went public in 1948; it has an outstanding balance sheet and an extremely stable revenue line and the No. 1 franchise in a business that is not going away. Cars may change, and trucks may change, and they will use different parts. But they are still going to use parts. What Genuine does is get any one of those 375,000 parts to a mechanic anywhere in the United States within 24 hours. The stock is yielding about 4.6%. In a brutal recession in the auto business, Genuine Parts just reported slightly up earnings. It is a highly defensive name.

What other trends do you see?

There is a secular trend toward green technology in the auto industry -- cars that are cleaner and use less fuel. Customers' attitudes have changed dramatically in the U.S. But with gas prices falling and incomes being pressed, that may slow down a bit. There may be less willingness for the customer to pay a premium for a hybrid vehicle, and there may be less economic motivation if gas prices fall. So we could see a little bit of a reversal here. That was one trend that put a lot of pressure on R&D budgets for these companies, and that may cool off a little bit.

Looking out, say, five to 10 years, what do you see?

There is immense pressure for consolidation, particularly in Western Europe, Japan and the U.S. I would be very surprised if there are three independent U.S. companies, and I'd very surprised if the smaller Japanese companies, such as Mazda, Mitsubishi [8058.Japan] and Isuzu [7202.Japan], stay independent. Also, there will continue to be a shift in value to these big suppliers. Because of the financial pressure on the auto companies, they will continue to outsource to these big suppliers that now have the people and the technology to be the best in making all of these systems in a car. For example, no car company makes a radio itself. It's quite conceivable that, 10 or 15 years from now, a lot of engines will be made by outside companies that have technology and scale.

Also, gas-electric hybrids and pure electric vehicles will become commercially feasible. And if it is electric -- and it increasingly looks that way -- the economics of auto-making are probably going to change a great deal. There will be a lot of value in the battery and in charging batteries.

Utilities are going to play a big part in the automobile value chain. That could present serious risk to automobile companies, which historically commanded good margins for the value they put in the car. The automobile itself could become a less important part of the total cost of ownership. You could see car companies partnering with electric utilities.

On that futuristic note, thanks, John.