Fitch: Macroeconomic Concerns Cloud Recovery for U.S. Autos in 2010

Fitch Ratings forecasts that weak macroeconomic conditions will lead to a slow recovery in industry sales for the U.S. auto sector in 2010, with U.S. light vehicle sales forecast to reach 11.1 million units next year. This would represent an increase of approximately 7.8% over the estimated 2009 figure of 10.3 million units.

Factors precluding a stronger bounce from trough levels include high unemployment, pressured consumer discretionary spending, the lost wealth effect from lower housing prices and a higher savings rate. Weak demand from daily rental and pressured municipal finances will also limit any rebound in fleet volumes.

While economic recovery is looming in the U.S., Fitch expects a much longer, drawn-out industry sales recovery for autos in 2010. Despite a number of improved variables in the auto industry since the depth of the crisis in 2009, even a rebound in U.S. unit sales to the level Fitch forecasts would leave much of the industry awash in negative cash flow in 2010.

The risk of a double-dip recession or another spike in gas prices remain present and could arrest any market improvement. However, liquidity for manufacturers and suppliers alike has improved due to expanded access to external debt and equity markets, including unprecedented support by the federal government. This is expected to support the industry during a protracted period of relatively modest sales growth.

In 2009, industry solvency was maintained as a result of U.S. government intervention through a variety of direct and indirect programs, a number of which are ongoing. The direct capital injections into Chrysler, GM, GMAC and Chrysler Financial, debt guarantees, support for bank holding companies, the TALF program, cash-for-clunkers, supplier guarantees, non-U.S. government aid and Department of Energy loans not only ensured that the industry could continue to operate, but also provided a mechanism for facilitating the restructuring of certain balance sheets and wage/benefit issues. Fitch estimates that support of the industry has totaled more than $125 billion.

In addition, renewed access to the bank, debt and equity markets by Ford and a number of Tier 1 suppliers has improved liquidity and addressed refinancing risk for a large part of the market. Even in the event of double-dip recession, reduced cash bleeds from aggressive restructuring actions coupled with improved access to capital should materially limit event risk in 2010. However, a muted industry recovery indicates that in Fitch's view, neither General Motors nor Chrysler will be in a position to access the equity markets in 2010.

Uncertainty surrounding the companies' near-term profitability, business models, and limited or uncompetitive independent access to capital by the company and its finance affiliates will limit investor appetite until there is more clarity on the companies' operating performance and prospects. GM's operations in China, however, could support an IPO valuation at an earlier date than would otherwise be warranted by the U.S. operations and the troubled Opel operations.

Given prospects for a weak rebound in industry sales and the requirement for large amounts of external capital, financial support by the federal government may be extended. A concern is that the industry, including suppliers, is caught in an 'airline-style' cycle where competitive industry conditions and weak margins result in 'boom and bust' cycles without the boom. Peak conditions may provide insufficient free cash flow to rebuild the balance sheet, restore liquidity and enhance debt capacity, leaving companies vulnerable to severe financial stress in succeeding downturns. As with airlines, this could lead to repetitive cycles of bankruptcies and industry restructurings. A number of suppliers have emerged from bankruptcy with untested business models and capital structures, which have and may result in double-dip bankruptcies. The manufacturers could also fall into the same pattern.

The cash-for-clunkers program had a negligible effect on industry volumes in 2009, but nevertheless did have several benefits for the industry. First, the scrappage of older vehicles helped to accelerate the steady improvement in the used car market, facilitating residual values and easing loss severities of captive/affiliate and non-captive lenders. Coupled with an improved production/demand balance in the industry, higher residual values should continue to support the market as a whole entering 2010. More importantly, the pull-forward of production brought some much needed production and revenue to the crippled supply base, and likely forestalled even more supplier bankruptcies.

Despite industry cost reductions, capacity shutdowns and a projected improvement in unit sales, industry margins will remain compressed over the near term, with even the best performers unlikely to achieve margins equivalent to those of the transplants earlier in the decade. Overcapacity will continue to characterize the industry, and pricing power is expected to remain insufficient to achieve adequate returns on required investments in higher content, regulatory compliance, technology and capital equipment. Over the longer term, the high fixed-cost nature of the industry, long-product development cycles and chronic over-capacity indicate that the industry will continue to be littered with failures - plants, product lines, brands and companies.

Competitive Dynamics:

Market share gains and losses will be less predictable over the intermediate term for a number of reasons. The easy market share gains of Toyota and Honda are over, with effectively no new market segments for these companies to enter and due to the fact that they are facing better-quality competition for their key mid-size and small car segments from domestic manufacturers and transplants alike. For Toyota, the company's image for quality has also been tarnished over the past several years. As a result, Toyota will be challenged to maintain the substantial volumes in key car segments achieved by its primary products. Kia and Hyundai have shown the largest increase in market share, and are poised to take more through an array of new products and increased capacity in the U.S.. Several points of market share, primarily from GM and Chrysler, are up for grabs due to the companies' downsized capacity, reduced or dated product offerings and adverse consumer sentiment.

The pending proliferation of technology offerings by global competitors over the near term could also fragment the market and further alter consumer buying patterns. Studies indicate that long-term brand loyalty among consumers for most product segments has substantially declined over the last several years. Ultimately, it appears that the U.S. consumer is more open to a wider variety of brand/product offerings, indicating that market share gains and losses could exhibit more of a moderate back-and-forth character among leading competitors (as has been seen historically in the pickup truck market when updated products are introduced), and based largely on the latest product offerings.

Evolving consumer attitudes toward cars and driving may also be undergoing a change - from a high-profile, lifestyle purchase to a more utilitarian purchase that is focused on cars primarily as mode of transportation. Fewer cars per family, holding on to cars longer and less driving could all be symptoms of a changing consumer relationship with the automobile, attitudes that could be exacerbated by environmental or fuel price issues.

Growth forecasts issued by global competitors -- by region, market segment, and technology -- appear on an aggregate basis to vastly outstrip even the most optimistic industry growth scenarios. Not all competitors can grow market share faster than the market, a fact that does not appear to be widely acknowledged within the industry. The capital committed to hybrid/electric vehicles across the industry, for example, when contrasted with potential market growth over the near term, will likely make an untenable business case for all but a few manufacturers, indicating a large amount of capital destruction. The small and mid-sized car markets, a focus of virtually all manufacturers, will also be a key battleground. Despite lingering industry overcapacity and competitive conditions, the lure of the U.S. market remains irresistible, with scheduled expansion by new and existing competition. Volkswagen and Kia will each be opening plants in the U.S. in 2010 targeting the mid-size market. In a bit of irony, it is probable that upon stabilization of the economy and industry sales volumes, the most lucrative part of the market is expected to be the large SUV and pickup truck markets, segments still dominated by the Detroit Three.

Meanwhile, the federal government is supporting not only GM and Chrysler, but also the electric car start-ups Tesla and Fisker through Department of Energy loan program. Growth and product development by Chinese and other international firms, on their own or through acquisition, are creating new entities with global aspirations. Excess distribution capacity and realignment of the U.S. dealer base will also facilitate the eventual entry of new competitors into the U.S. market.

Regulatory/Legislative Issues:

Legislative and regulatory changes will be primary drivers of industry trends in the U.S. and globally both in the short and long-term. In simple terms, this will likely lead to reduced demand, higher capital/fixed-cost requirements, and reduced margins. Changes to government policies, as is occurring currently, can rapidly and materially change demand, investment, returns and competitive position. A look at various proposals or regulations around the globe - fuel taxes, tax credits, gas guzzler taxes, urban congestion or pollution measures, alternate transportation subsidies and credits, alternate-day license plates, etc. - illustrate a wide variety of government prerogatives that are being enacted or discussed. These developments also serve to raise the cost of, and reduce access to, external capital for the industry.

Access to Capital:

Chrysler and GM, and to a lesser degree Ford, are all competitively disadvantaged versus better-capitalized transplants, from a capital/R&D funding perspective and from their ability to finance dealers and retail purchases at economically competitive rates. GM and Chrysler are still dependent on U.S. government programs for these purposes. However, auto-loan paper has been a steady performer among securitized asset classes, which should support access to this market as economic conditions improve. Recent performance has been aided by the improvement in the used car market and residual values, although access to the ABS market may vary by individual manufacturer based on the perceived fate of certain models and brands, the impact on those residual values, and the willingness of lenders to accept certain models as collateral.

The growth of third-party creditors, particularly credit unions, indicates that more financing is being done at arms-length, market-based pricing. This could be a positive sign reflective of a more disciplined approach to production, inventory and incentive practices by manufacturers than has been experienced in the past. Incentives, however, will remain pervasive as a marketing and inventory tool, to the benefit of competitors with stronger balance sheets.

Although Ford (IDR rated 'CCC' with a Positive Outlook by Fitch) will remain pressured from its debt burden and other financial obligations, the company's access to the bank, unsecured debt and equity markets for the time being present a competitive advantage versus Chrysler and General Motors (see the Nov. 9 press release for further details on Fitch's views on Ford). Over the intermediate term, Ford's operating performance is expected to drive the quality of its balance sheet. Ford is best positioned from a production and product standpoint to further strengthen its balance sheet, while GM and Chrysler remain in the midst of restructuring plans and face a more difficult road to achieving the required independent access to capital for operating and dealer/consumer financing purposes.

The policies of the federal government, through existing, altered or new programs, will continue to affect industry liquidity for the manufacturers, their financial arms and the competitive environment. Under one pending proposal, Department of Energy funding to the industry could rise from $25 billion to $50 billion.

Foreign Exchange:

Although the global auto industry is accustomed to dealing with volatile exchange rates, the prevailing weakness in the U.S. dollar is another variable that will have an impact on financial performance. Toyota will be the most adversely affected by a weak dollar due to the high proportion of its product shipped to the U.S. from plants in Japan. Honda and Nissan will also be impacted, but to a lesser degree. These pressures are likely to be absorbed in margin, providing little relief from pricing pressures in the affected segments. Toyota recently announced a substantial marketing budget for the U.S., through a variety of programs, indicating that Toyota will combat cost and capacity pressures with their capital strength, limiting any industry pricing relief and sustaining industry margin pressures. U.S. manufacturers have also spent years re-channeling their supply chains to low-cost locales, chiefly Asia, and the economics of this equation have changed with currency fluctuations. Most prominently, the weaker dollar will continue impair margins due the sustained higher cost of USD-priced commodities. This is expected to be felt on the cost side - for raw materials such as steel and copper -- as well as on the demand side due to higher oil and fuel prices.

Pensions:

Despite the recovery in financial markets, the auto and auto supplier industries also face pension obligations resulting from heavy portfolio losses during the market turmoil. In an effort to conserve liquidity, companies have been contributing the minimum required amount, which will be insufficient to close the funding gap (assuming average market returns) and which will result in accelerated contribution requirements down the road. The capability to defer funding has been assisted by government funding relief, which could continue.

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