2009: Slow Auto Sales, Higher Prices

The time of heavy rebates is over as carmakers get ready to raise prices to increase profits. Get ready for sticker shock

On Tuesday, Dec. 16, Moody's Investors Service suggested that, should Detroit free-fall into bankruptcy, the nation's economy should suffer "depression-like" consequences. In spite of that dire prediction, in time this country will again be able to look forward to the future—provided we fix something first: At the national level, it seems, our elected officials' ability to prioritize is broken.

Detroit, feeling the same crunch you and I are, goes to Congress asking for a bridge loan of $14 billion to continue operations, thereby saving the jobs of potentially millions of Americans. Yet this request for help to keep unemployment from multiplying overnight ends up inciting one of the worst partisan debates of the past five years, in which the sole intent of some was, demonstrably, to finally destroy our industrial base. Meanwhile Bernard Madoff, the ex-chairman of the Nasdaq stock exchange has been accused of running a that defrauded investors of $50 billion—unchecked over possibly decades—and yet the partisan debate still is trying to make the case that it's Detroit failings that is the real problem.

Now that's a misplaced priority.

They Understand Something We Don't

Notably missing from the U.S. auto bailout debate is this fact: The problems in the automotive industry are not ours alone. They are worldwide—and every other major country is rushing to ensure that its auto industry survives until better days.

Daimler (DAI) has made some cash payments to its European dealers to keep them functioning. Volkswagen (VOWG) has applied to tap Germany's $650 billion bank bailout fund. The British government worked on a plan for the survival of the country's automakers last weekend, while the China Export & Import Bank lent $1.42 billion to Chery Automotive to keep that company afloat. The Swedish government will give $3.5 billion to stabilize both Volvo and Saab. On Tuesday, President Nicolas Sarkozy of France said he would move to save the auto industry, and the Canadian government has already committed to adding 20% more in capital for Detroit over whatever figure Washington might come up with. Canada added that it would do whatever is necessary to avoid a "doomsday scenario" for the industry. Ain't that a kick in the backside? Canada is willing to match one-fifth of what America contributes to save Detroit, while certain elected officials in the U.S. are doing everything in their power to end the Big Three's existence.

It seems to shock people, including the many reporters I've spoken with who are covering this event, but it's true. Auto companies are in trouble all over the world, but except for America they are getting immediate financial assistance. This turns the rationale that only Detroit is having problems—and therefore should be allowed to go belly-up.

Incentives Madness

For some time, I've written that for Detroit to survive long-term the supersized incentives would have to end. Contrary to what the "union labor" bashers howl, it is the size and frequency of those rebates that keep Detroit from profiting on the vehicles it builds. In the interim, the incentives have gotten even crazier, but this is part of the endgame.

Just a few examples: Last week General Motors (GM) upped the rebates on the already popular Chevrolet Malibu to $4,250 and added another grand on the Impala's.

Today you can legitimately buy a new Hummer H3 for under $20,000. GM now has a $10,000 rebate on any truck with a Duramax diesel engine, and their midsize SUVs' rebates can go as high as $8,000. If you qualify for all of the potential rebates, a Cadillac CTS might come with $10,000 cash back. Ford (F) and Chrysler have similar incentives.

This seems to me to be an insane corporate decision, considering that GM also announced that it is going to cut 250,000 vehicles out of first-quarter production. Likewise, Honda (HMC) announced that it would trim North American production by a further 119,000 vehicles.

Keep in mind that when rebates are offered on vehicles sitting on dealers' lots, the manufacturer deducts those rebates' cost as a selling expense in the financial quarter in which they're offered. Typically, rebates quickly improve sales; dealers then order more vehicles to replace those sold, and the auto manufacturers book the profits on the new vehicles, theoretically offsetting the rebate expense.

At least, that's the way it has happened over the past few years. Only the timing is wrong this time: In December most automakers quit building vehicles to ship before Christmas. This means that Detroit has the cost of the rebates, but barely over a half-month of production profits to offset the sales expense. More important, many automobile factories will go on an extended Christmas holiday in January, so the lost rebate expenses can't be recovered with January production.

So, why would Detroit do everything in its power to clear out dealers' inventories across the country, while at the same time making it more difficult to restock those empty lots? Not to mention having nothing but negative sales expense and little potential to recoup it with new production profits. And Honda and others are doing this, too.

Buy Before Killer Sticker Shock Spreads

I've seen this before, in 1974, 1980-81, and in 1992, when Detroit automakers found their backs against a wall. It's based on one fundamental reality: Detroit is setting up for a continued downturn in the market. Remember, just a year ago Americans were still buying around 16 million new cars annually; now, GM's forecast for 2009 is right at 11.8 million total new car sales for the industry. J.D. Power & Associates, which, like BusinessWeek.com, is a division of The McGraw-Hill Companies, came up with a similar forecast, and CSM Marketing is right in there among them.

Automotive executives are trying to get into a position where their companies can make money no matter how far sales fall from their previous peak. And if history is any guide, what we witnessed in 1974, 1980-81, and 1992 was a fairly consistent series of price increases to create profits even as sales tanked.

You would think it counterintuitive to raise prices in slow times, and maybe in some industries that would be true. But it has become painfully obvious what happens to automotive profits when you try to hold on to last year's sales volumes by reducing prices in a market slowdown: Detroit's red ink is proof of that.

Moreover, when car sales turn down, it's because the impulse, or "want" buyers have left the market. Only the "need" buyers, a class that is there all the time, good years and bad, remain and become the bulk of the industry's customers. A need buyer is defined as someone who holds on to a vehicle for an exceptionally long time before trading—often until fixing it would cost more than it's worth. But at that point, in spite of higher sticker prices, they have no choice but to replace their vehicles.

The higher prices are already happening. One GM car I reviewed just six months ago has already had its price boosted by nearly $2,000, and sure enough, it's on a popular model that typically sells without any rebate.

It's Always Darkest…

Historically in this automotive financial cycle, companies take their money-losing operations and restore them to massive financial health once the economy—and therefore new automobile sales—start to take off again. Remember, many thought GM was going to go bankrupt in 1992 (while financially Chrysler might have actually been there), and by 1997 GM was back to making $6 billion annually, while Chrysler was the most profitable car company per car built.

Japanese automakers faced price increases of up to 25% during 1994-96, the result of the exchange rate of their currency against ours. And while Japanese car sales suffered during that period, including their luxury car divisions, once the automobile market recovered and set new records for volumes in the late '90s, they minted money. Absolutely no one seemed to notice that the price of an Acura Legend grew from $30,545 in 1991 to $45,000 in 2000, or that the $40,000 Lexus LS series has moved into the $70,000 range.

GM cars' prices jumped 10% across the board from the 1974 to the 1975 model year—and within 12 months America's new car sales had a record year. The most extreme case might have been the Mercedes 300SD; introduced in late 1978 at $26,995; by 1982 it cost $42,500. Guess what? Mercedes dealers couldn't keep the best colors in stock that year; most were sold before they ever got to the dealerships. And like the Japanese, at the time Mercedes had currency exchange problems.

Yes, it's bargain-basement time at every dealership in America, and it cannot continue. In case you are wondering how the prices can be increased so much and people won't care in the future, that's human nature. When downturns in the economy end, optimism spreads even faster than gloom did; people are so delighted just to be buying again that the price is less important than the return of enough confidence to buy something big and beautiful.

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