GM and Ford: Cost Cuts Only the Start

These carmakers aren't likely to haul themselves out of the ratings ditch anytime soon, according to S&P

From Standard & Poor's RatingsDirect

U.S. automakers General Motors (GM) and Ford Motor (F) have taken increasingly aggressive steps in 2006 to slash costs and bolster performance in their North American operations. Still, successfully addressing adverse trends that have been gaining momentum—in some cases for years—will itself be a multiyear process.

Automotive operations outside of North America are almost of little consequence in the near term, because of the magnitude of difficulties in what is by far GM and Ford's largest market. External pressures continue to mount from many directions in the North American market, including the possibility of continued deterioration in product mix, eroding market share, and early signals of a weakening macroeconomic picture. Standard & Poor's believes that the risk of a recession occurring in 2007 has increased to around 35%.

But even without a sharp downturn in light vehicle sales, stagnant volumes will keep competition intense. In sum, we view the automakers' accelerated cost-cutting initiatives as a necessary precondition to any sustained improvements in credit quality. But a successful, multiyear turnaround on the revenue and product side will also be required. In the meantime, performance in North America will remain weak for the foreseeable future.


  On the positive side, we view GM and Ford's actions during 2006 as confirmation that the board and managements of both companies remain committed to turning around their automotive operations without resorting to a financial restructuring. Because of their current mindset, combined with their still-sizable cash balances, we continue to view bankruptcy risk as limited for both automakers in the very near term. There's currently more visibility on the success of GM's cost efforts than with Ford's, given GM's earlier announcements and some demonstrated progress.

However, Standard & Poor's ratings on GM and Ford remain at very low speculative-grade levels, with further downgrades possible. Unlike Ford, GM bears the execution risk of resolving its economic exposure to bankrupt supplier Delphi Corp. and the pending sale of a 51% stake in finance subsidiary GMAC.

Meanwhile, the already similar turnaround plans for both companies are becoming even more alike. The cost reductions under way need to address not just legacy structural costs and market share losses, but also the unfavorable mix shift away from light trucks that has been rapidly taking shape for the past year or so.


  On Sept. 19, S&P lowered its ratings on Ford to B from B+, reflecting the continued deterioration in its North American automotive operations, which are now expected to remain unprofitable until at least 2009. Worsening trends in 2006 will lead to a higher-than-expected use of cash since Ford's previous downgrade in June, and 2007 also will be a challenging year for cash usage because large head-count attrition cash payments will need to be paid during that year. Ford's expanded cost-reduction program in North America, while important, cannot be expected to gain much real traction until 2007.

Through the first eight months of 2006, Ford sold nearly a quarter million fewer pickups and sport-utility vehicles (SUVs) than a year ago, a 17% drop. As consumers have shifted into more fuel-efficient vehicles, Ford's ratio of light truck to overall vehicle sales fell to 62%, from 67% in the year-earlier period. This mix shift has a greatly magnified impact on Ford's bottom line because of the smaller vehicles' lower margins, and this shift is unlikely to reverse.

GM's ratings remain on CreditWatch with negative implications while the company works to resolve its Delphi exposure and complete the sale of a majority stake in GMAC. GM's financial performance has been somewhat better than Ford's in 2006, while the reverse was true in 2005. This partially reflects GM's strong cadence of new products this year, evolving pricing strategies, and the early benefits of its extensive cost reductions.


  For the rest of 2006, both companies are slashing production for the fourth quarter (Ford by 21% and GM by 12% compared to a year earlier quarter) in an effort to reduce dealer inventories to more manageable levels. This will particularly pressure Ford's results due to the magnitude of the cuts and their concentration in light trucks.

Looking further ahead, critical labor negotiations with the United Auto Workers (UAW) are scheduled to take place in fall 2007. The union has maintained a largely supportive posture through GM and Ford's recent round of restructuring efforts and health-care cost agreements, although it recently took a tougher stance with Chrysler on the retiree health care issue. It remains to be seen whether GM and Ford will sustain their bargaining momentum into the fall 2007 talks.

Many of the cost reductions announced this year will have to be included in the new contract. However, we aren't incorporating any further significant concessions from the UAW in 2007 into the current ratings of GM and Ford. A broadly favorable new contract in 2007 (an unfavorable contract seems somewhat less likely) would have to be evaluated in light of the industry conditions and the respective company's financial performance.


  Meanwhile, macroeconomic factors, which had been at the automakers' backs, have turned more negative. A recent downturn in consumer confidence, coming on the heels of higher interest rates and an already softening housing market, is an ominous sign for industry sales volumes. Potential car buyers are less likely to produce ready cash from refinancing their mortgages, and discretionary incomes are being affected by rising energy prices and the upward reset of many adjustable-rate loans.

Our baseline expectation for 2007 U.S. light-vehicle sales is for lower unit sales than 2006, but not dramatically so. We expect 2007 sales to be comfortably above 16 million units.

Looking Ahead

Visibility remains severely limited in the North American automotive sector. For this reason, it's too early to predict what results will look like for full-year 2007, much less subsequent years. Nevertheless, S&P will be paying close attention to the following trends as GM and Ford carry through on their cost-cutting initiatives while attempting to stabilize pricing and introduce new products:

• The stability of North American sales. A recession or significant erosion of consumer confidence and discretionary spending levels could lead to a more significant decline in industry sales. In past downturns, it wasn't uncommon for sales to drop 10% or considerably more. A repeat of this would leave GM and Ford little room to complete their turnarounds.

• Product acceptance. After some early success with its remodeled SUVs, GM is launching its new pickups this fall. Meanwhile, Ford will begin selling its new Edge crossover vehicle (CUV) in the coming months, while GM also has several new CUV models planned.

• Inventories. GM and Ford hope to reduce dealer inventories to more manageable levels by the end of 2006 through recently announced fourth-quarter production cuts. However, if sales are disappointing, further production cuts may be necessary in 2007.

• Pricing. GM has attempted to rein in incentives this year by lowering list prices, which has had modest positive impact on average transaction prices. Many past efforts to instill pricing discipline in the industry have failed as GM and Ford resort to higher incentives to support sales.

• Suppliers. Some weaker auto suppliers with heavier exposure to the domestic manufacturers may face financial distress as a result of the latest round of production cuts, which may affect GM and Ford's supply chain or complicate product introductions.

• Raw material costs. Rising steel, copper, plastic resin, and other commodity prices frustrated efforts by the automakers to reduce purchasing costs in 2006 and will continue to hamper their results into 2007. Many suppliers have agreements in their contracts to pass on higher raw material costs, sometimes after a time lag, leaving the long-term risk of higher prices to the automakers. We aren't incorporating the benefits from any eventual easing of commodity prices into our ratings.

Before it's here, it's on the Bloomberg Terminal.