Autos

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

Once upon a time, the battle for the crown of world's biggest automaker was a one-horse race.

Since overtaking Ford Motor Co.'s sales in 1931 -- not that long after the last Model T rolled off the production line -- General Motors Co. was the undisputed global market leader for the best part of eight decades.

In 2008, Toyota Motor Corp. pulled ahead, before itself being usurped by Volkswagen AG in 2016. The Germans' reign looks set to be brief, however. Buoyed by the integration of Mitsubishi Motors Corp. last year, the Renault-Nissan Alliance sold 5.27 million vehicles in the first six months of the year, putting it on track to join the 10 million cars-a-year club as 2017's market leader, barring a second-half slump.

Pole Position
General Motors' multi-decade run as the world's biggest carmaker by volume has given way to a free-for-all
Source: Bloomberg, company websites, Gadfly calculations
Note: Calendar 2017 figures represent first-half figures annualized to show changing positioning.

Before Carlos Ghosn starts spraying the champagne, it's worth considering where that 77 years of sales dominance left GM: just six months away from one of the biggest bankruptcies in U.S. history.

It's a cliche of the industry that automobiles are a volume business. Among a fiercely competitive set of companies producing fundamentally similar products on wafer-thin margins, size is one of the few defensible economic moats.

It's a nice theory. Unfortunately, the evidence barely supports it.

Small Is Beautiful
The correlation between revenue and three-year average operating margin is mildly negative in the auto industry
Source: Bloomberg
Note: Based on companies with at least $1 billion of trailing 12-month revenue.

There is a mildly positive correlation between scale (as measured by revenue) and three-year average operating margin in some industries -- consumer electronics and internet sites, for instance. But when it comes to autos, size if anything seems to be very weakly correlated with narrower, not broader profit margins -- in other words, the bigger the car company, the weaker the profits.

It's easy to see why scale might not be the advantage it's cracked up to be, but why should it be a full-blown disadvantage?

Part of it is probably that if you make a lot of cars, you have to shift a lot of cars, too. That means that when demand starts looking soft -- as it is in the U.S. and China at present -- you end up having to offer generous discounts to get them off dealers' lots, averaging about $3,550 per vehicle in the U.S. in June, according to consultancy ALG.

Even that may not be enough. Hyundai-Kia's U.S. sales fell 18 percent in July from a year earlier, according to monthly data published Tuesday, while GM's were down 15 percent. Only Toyota saw any improvement in volume numbers. Nissan Motor Co. and Hyundai Motor Co. both blamed their U.S. incentive spending for disappointing results in the most recent quarter. As Gadfly's Shelly Banjo has written, if the weakness in North America simply causes volumes to return to long-run averages, the downside for carmakers could be substantial.

Engine Trouble
Only Subaru, Daimler and BMW are close to the 1 time ROIC/WACC ratio that represents economic profits
Source: Bloomberg
Note: Based on five-year averages of annual ratios. ROIC/WACC ratio represents return on invested capital divided by Bloomberg estimate of weighted average cost of capital.

Another reason might be the fact that size encourages companies to misallocate capital. Ever-tightening emissions standards and the looming advent of electric and self-driving automobiles mean the industry is evolving at a breakneck pace. Gadfly has, to be sure, encouraged automakers to spend generously to win this technological race, but there's no question that it's an expensive game.

At the moment, the costs appear to be outweighing the benefits. Take a look at global carmakers in terms of economic profit -- the extent to which returns on invested capital outstrip the weighted average cost of capital itself:

Less Is More
Just five automakers worldwide make returns above their cost of capital
Source: Bloomberg, Gadfly calculations
Note: Returns estimates based on five-year averages of annual WACC/ROIC ratios. WACC based on Bloomberg estimates. "Outright losses" means WACC/ROIC ratio is less than zero, "returns below the cost of capital" means between zero and one, "returns above the cost of capital" means a ratio greater than one.

Based on the past five years' average performances, just five big automakers come even close to returning their cost of capital, and only three of that number sell significant volumes outside their home markets: Subaru Corp., Daimler AG and BMW AG. The trio combined sold about as many cars last year as the expanded Renault-Nissan Alliance has built already in 2017.

That's a powerful argument that Hyundai-Kia and any prospective suitors for Fiat Chrysler Automobiles NV should heed against pushing too hard to join the 10 million club.

Electric Warrior
Tesla's production volumes are about 1 percent of the big four automakers, but only Toyota and VW are worth significantly more
Source: Bloomberg, Gadfly calculations
Note: Renault-Nissan group valuation calculated as market capitalization of group companies minus value of Nissan's share of Mitsubishi and Renault's share of Nissan. Mitsubishi incorporated into valuation as of October 2016.

Go back 65 million years, and the land, seas and skies were ruled by fearsome giant reptiles that could afford to ignore the mammals scurrying about beneath their feet. Then a meteorite hit, and the beasts with the big hungry metabolisms were wiped out. The astonishing performance of Tesla Inc.'s share price relative to companies that make about 100 times as many cars suggests many investors see the same fate awaiting big auto.

Those fears may be overdone, but the valuation mismatch is an indication that smaller automakers -- and executives like GM's Mary Barra, who alone among the big four looks to be cutting production and focusing on returns, not size -- could be on to something. In this industry, it's not about how big you are. It's how you use it that counts.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net