Detroit's auto bubble pain
Automakers are suffering because sales were artificially boosted by cheap credit and the Big Three thought this could last forever.
NEW YORK (CNNMoney.com) -- Automakers are counting on a rebound in demand by 2010. But that could turn out to be unrealistic because of an "auto bubble" the Big Three helped to create during the past few years.
Cheap financing, easy credit conditions and attractive pricing on cars due to overcapacity in the U.S. auto market caused record sales earlier this decade.
Experts agree those three conditions are going to be missing for years to come, and that sales will continue to be weaker than normal at least through 2011 or 2012.
And that may make it a lot tougher for executives of General Motors, Ford Motor and Chrysler LLC to make the case that they have a viable turnaround plan when they again appeal to Washington for $25 billion in bridge loans later this week. The Big Three will present their business plans to Congress on Tuesday, and appear before a Senate committee Thursday and a House panel Friday.
"It's going to take us many years to get back to a trend level of sales, let alone the levels you might hope to see," said Bob Schnorbus, chief economist with J.D. Power & Associates.
From 1999 through 2006, U.S. auto sales averaged 16.9 million vehicles a year. Before that period, there was only one year when annual sales even hit 16 million.
And these strong years came at a time when the number of licensed drivers was posting a modest 1.1% annual gain, suggesting that the sales increases were way ahead of fundamentals. In other words, people bought new cars or trucks because they could, not because they necessarily needed to.
"We had above-trend years, some of which was caused by an incredible growth in household net wealth that later we found wasn't real," said George Pipas, director of sales analysis and reporting for Ford Motor.
Pipas added that sales were "artificially high" in other years "due to a higher and higher level of incentive spending.".
"Now when we look back, we see elements of a bubble," he said. "Does that present a problem today? Of course."
The strong sales also allowed General Motors (GM, Fortune 500), Ford Motor (F, Fortune 500) and Chrysler LLC to generate healthy profits, which led them to agree to contracts with the United Auto Workers union that they ultimately couldn't afford over the long-haul.
But as import brands started to eat into Detroit's market share, it became tougher for the Big Three to stay profitable. By 2005, GM and Ford were losing money on their North American auto operations. Chrysler joined them losing money a year later.
In response, they all closed factories and cut staff to bring their capacity more in line with demand. But they didn't cut deeply enough.
Each of the Big Three is now making additional cuts in capacity, especially for sport/utility vehicles and other light trucks. That is a sign that these companies did not accurately predict how sharply demand could fall once the auto bubble burst.
Detroit wasn't alone in making this mistake. Toyota Motor (TM) and other Asian and European automakers increased their U.S. capacity earlier this decade as well.
Toyota has since had to cut its sales and profit outlook because of the weakness in the U.S. It and other Asian automakers have also been forced to rely on bigger cash-back offers and other profit-sapping incentives to boost sales.
J.D. Power believes that U.S. sales won't again reach the 16 million vehicle level until 2012 at the earliest. And Schnorbus said he isn't confident that sales will reach that target by then.
This is an astonishing fact when you consider that many in the industry had previously thought 16 million in annual sales was a sign of relatively low demand until the current collapse in sales.
Even GM CEO Rick Wagoner conceded in testimony to Congress recently that the level of auto sales reached during the boom years are probably out of reach for the foreseeable future.
"We think that was actually, probably, in retrospect, higher than a normal trend because of the low energy cost and the cheap credit," Wagoner said.
This has long been the case, due mainly to the number of cars and trucks owned by businesses. But that gap grew much wider during the boom years. In 1998, there were about 12 million more vehicles than drivers in 1998. By 2006, the difference grew to 34 million.
That kind of imbalance couldn't be maintained, even before the economy fell off a cliff. To that end, U.S. sales slowed to 16.1 million in 2007 and have plunged this year thanks to high gas prices earlier in the year and then the credit crunch.
Sales are now at their worst levels in 25 years, with a seasonally-adjusted annual rate of only 10.5 million vehicles in October. And when adjusted for population, GM said October was the worst month for the industry since the end of World War II.
November sales, which will be announced on Tuesday, are likely to be comparable to October's total. For the full year, sales are expected to be just over 13 million and the automakers themselves are forecasting a drop to around 12 million in 2009.
But the Big Three is hoping sales will start to bounce back in 2010 thanks to pent-up demand. They argue that this rebound, combined with additional cost cuts and labor contract savings they'll see that year, will get back on their feet financially.
David Cole, chairman of the Center for Automotive Research, a Michigan think tank supportive of the bailout, said he still believes that sales can bounce back quickly because they've fallen so dramatically during this downturn.
"Right now we're at depression level sales. Sales of 14 million a year is what we'd expect for recession levels," he said.
But he agrees that the bubble that occurred during the boom is a big reason why Detroit is in such serious trouble. Now that it has burst, there is no easy way out of the crisis for the Big Three.