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Quality Issues Could Stall Nissan's Plan

Knock off the grandiose deal-making and keep your eyes laser-focused on Nissan (NSANY). That pretty much sums up the sentiment of most analysts disturbed by the deteriorating numbers at Japan's second biggest auto maker. Morgan Stanley recently downgraded Nissan's stock, while J.P. Morgan (JPM) this month trimmed Nissan earnings forecasts. The carmaker's March to June results are due out on July 25, and are expected to be less than stellar.

Nissan and Renault joint CEO Carlos Ghosn, however, shows absolutely no sign of losing interest in a possible alliance between GM (GM) and Nissan and Renault (see, 7/2/06, "The Trio That Could Transform Autos").

During a July 21 gathering with reporters in Tokyo, Ghosn pointed out that auto analysts and pundits had an even more toxic reaction seven years ago when Renault made a daring move to sink billions into Nissan and took a controlling stake. The move was a triumph for Renault, and the revival at Nissan was one of the most dramatic in automotive history. "Reaction today, compared with the reaction when Renault announced an alliance [with Nissan] is much better," Ghosn said.

RECALL COSTS.Whether a broad tie-up with GM is a wise move for Renault-Nissan is open to debate. What's not, is the earnings stall at Nissan. Analysts are predicting Nissan will report an operating margin slump of up to 30% compared with a year earlier. And Nissan's lackluster performance will almost certainly intensify calls for Ghosn to spend less time on his mating dance with GM, and more time on Nissan and Renault.

"The results are going to very disappointing," says Tsuyoshi Mochimaru, an analyst at Deutsche Securities in Tokyo. "I suggest Nissan terminate the negotiations as soon as possible."

Mochimaru reckons Nissan's quarterly sales will fall 4%, to $22.1 billion, in comparison with a year ago, while operating profits will slump 19%, to $1.44 billion. However, the profit squeeze could be much worse depending on the cost of recalls, including the 87,000 faulty Altima sedans in the U.S. that Nissan is likely to book this quarter. "We could see an operating profit decline of more than 30% as an unpleasant surprise," warns Mochimaru.

Analysts' longer-term outlook for the company is also deteriorating. On July 22, Morgan Stanley downgraded Nissan's stock from "overweight" to "equal-weight." On July 13, J.P. Morgan analyst Takaki Nakanishi also slashed his Nissan earnings target for the year from $4.5 billion, to $4.1 billion, blaming lower-than-expected production volumes and a rise in quality control costs.

MORE DECLINES.While grim, Nissan's weakening performance isn't a total surprise. Sales in the key U.S. and domestic markets have been sliding ever since Nissan met a self-imposed target to increase sales by one million units in the three years to September, 2005. During the first six months of 2006, Nissan's sales in the U.S. fell 5.7%, to 511,768—the first fall year-on-year since 2001.

In Japan, passenger car sales slumped 18.3%, to 354,734—the first decline in two years. Production is also down—21% in Japan and 15.7% in the U.S., due to lower output of full-size pickup trucks and SUVs. In total, Nissan's non-Japanese production fell for the first time in seven years. And since October, Nissan's stock price is down 8.1%. By contrast, rivals Honda (HM) and Toyota (TM) are up 14.6% and 13.7%, respectively.

One reason for the decline: a lack of new models over the last 12 months in both markets. While Nissan is about to unleash several new models, including remodeled versions of the best-selling Altima and Sentra sedans in the U.S., the benefits won't filter through to the bottom line for several months.

BAD REVIEWS.Another factor has been the poor performance of vehicles released during the Nissan 180 three-year business plan launched in October, 2002. Under the plan, Nissan focused on launching more profitable larger vehicles in the U.S—such as the Titan full-size pickup—rather than smaller, more fuel-efficient models. But higher oil prices since 2005 have slashed demand for gas guzzlers and have hit earnings.

Making matters worse, the new Sentra sedan—until the launch of the Versa this month Nissan's smallest U.S offering—was delayed after test customers hated the original design (see, 6/12/06, "Nissan: Potholes Ahead").

Quality also remains a worry for investors. As Ghosn is striving to crank out an extra million units during the Nissan 180 plan, there have been some quality missteps that tarnished Nissan's reputation. According to Consumer Reports magazine, four Nissan and Infiniti vehicles built at the company's Canton (Miss.) plant are among the least reliable in the industry. In June, Nissan recalled the 87,000 U.S.-built Altima sedans due to faulty oil rings that could cause engines to catch fire.

FIRST THINGS FIRST.Of course, recalls are a fact of life in the auto business and Nissan insists improvements are being made, but J.P. Morgan's Nakanishi warns quality problems will remain a serious concern for the foreseeable future. He estimates fixing the Altima oil-ring defect will likely work out to $2,000 per vehicle, while Nissan's warranty costs per vehicle have more than doubled in the last two years and won't peak until 2007. "Nissan's ability to gets its quality issues in order will have a major bearing on its medium-term earnings prospects," says Nakanishi.

Add Ghosn's decision last summer to begin running Renault and Nissan simultaneously, and it's understandable that Nissan-watchers reckon Ghosn's first priority should be sorting out the Japanese auto maker's problems rather than chasing GM (see, 4/27/05, "Carlos Ghosn on His Double Duty").

"The alliance between Renault-Nissan and GM appears to make little sense for Nissan at this time," Morgan Stanley's Noriaki Hirotaka noted in a report to clients last week. "We think the core job of Nissan's management is making cars, not deals." Of course, Ghosn has proved critics wrong in the past, and a deal with GM could prove fruitful for Nissan in the longer term. But until Nissan's fundamentals perk up, the brickbats will keep coming.

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