Beyond the bad news.

The lost six months have been a very add time for the outomotive industry. The convergence of multiple events has led to an avalanche of bad press that has shaken many industry participants' belief in the health and long-term viability of this sector. While much of the bad press is warranted, there are some underlying positive fundamentals of this industry. To really understand what is going on and where to be concerned, we need to look at the fundamental issues impacting the industry.

THE "SOFTENING" OF THE NORTH AMERICAN MARKET

While the perception is that the overall automotive market in North America has been struggling of late, the reality is that we have continued to experience robust sales of vehicles over the last few years. It is important to remember that, on a macro basis, light vehicle sales in the U.S. are still very strong. While they have tapered off a bit from the recent high in 2000, sales are still above the long-term trend line. In the first-half portion of 2005, they are running less than 1% off last year's level. Even better news is the likelihood that the five-year outlook for sales and production will also remain very positive. The obvious problem with this rosy scenario is the impact of the share mix change that is happening between the traditional Big Three and the New Domestic manufacturers.

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CONTINUED MARKET SHARE DECLINE OF THE BIG THREE

The major surprise of the last two years has been the continued share decline of the Big Three. At the beginning of 2003, the share mix between the Big Three and the New Domestics was 60.36% to 39.64%. In the first quarter of 2005, the Big Three position deteriorated to 57.91% market share. One of the questions we are most frequently asked is, "Will this drop in market share ever stop?" The answer, at least in the short-term, is "Yes." The large annual declines of the last five years are unlikely to occur over the next five years. While the reasons are numerous, a major factor is that most of the increases in New Domestic plant capacity in North America have already occurred. In addition, there are some major new product launches planned by the Big Three (e.g. the GMT 900 program) that will positively impact their position.

THE BIG THREE STILL DOMINATE NORTH AMERICAN PRODUCTION

While market shares have declined, it is important to keep in mind that in terms of overall volume, the Big Three still produce an enormous number of vehicles. Of the approximately 16 million vehicles that will be produced in North America in 2005, for example, over 11 million of them will be produced by the traditional Big Three manufacturers. There is nothing that suggests this production dominance will change in the next 5-10 years. The challenge is for the OEMs to learn to deal with the added complexity of vehicle proliferation and shorter vehicle lifecycles.

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THE DETERIORATION OF THE TRUCK SEGMENT

There has been a lot of press lately about the American consumers' trend away from the highly profitable large SUVs and pickup trucks. Most of this consumer change in attitude has been attributed to the rise in oil prices. While some of this is true, we at IRN believe that it is less oil prices than it is an aging product line that has caused most of this sales decline. There is a significant amount of new product planned by both the Big Three and the New Domestics that should positively impact both segments. While there will be some decline in profitability due to increased competition, these segments should remain industry bright spots.

UNSUSTAINABLE COST STRUCTURE OF THE BIG THREE

The most volatile issue for the Big Three in the near-term is the need to address their current untenable cost structure. While the talk from these companies focuses mainly on the high cost of health care, their problems run much deeper than that. From too many assembly plants, to high labor rates, to cumbersome and expensive program launch systems, to pension and retirement liabilities, the Big Three (in particular Ford and GM), need to completely redesign their business models. Their ability to do so while simultaneously trying to improve the quality and consumer acceptability of their products will be a major challenge. While they have historically shied away from making the painful decisions necessary to improve their competitive position, it appears that their problems have become substantial enough that they finally have no choice. While this should lead to a much healthier outlook for the traditional manufacturers going forward, the transition is likely to be painful for everyone concerned.

THE NEW DOMESTICS CONTINUE TO EXPAND AND IMPROVE THEIR PRODUCT OFFERINGS

It is a telling comment when the head of Toyota offers to increase vehicle prices to give the Big Three some "breathing room" to address their multitude of issues. (Our guess is that he made the offer mainly to infuriate his struggling competitors.) The point is that most of the New Domestic manufacturers have been minting money the last few years indicating that the automotive industry isn't a bad place to be if you have the right product and the right cost structure. To condemn the entire industry because of the continued struggles of the Big Three ignores the overwhelming success of the New Domestics and fails to focus on the classic structural shift taking place between old and new business models.

AMERICANS CONTINUE TO HAVE A LOVE AFFAIR WITH VEHICLES

Last and most importantly, the American consumer still loves vehicles. In the end, that's what really matters. Most consumers still think in terms of their dream car and they are likely to continue the trend of owning a higher number of vehicles per household. The huge success of the new Mustang is a great case in point. Build a vehicle that clearly understands its target market, and people will beat a path to your door. While the bad news will continue for a while as the traditional OEMs and their significantly dependent suppliers struggle to change their business models, the underlying demand for vehicles is not in question. My personal favorite data point for this is the fact that one of the most popular shows on cable is "Pimp My Ride". Given that fact, things can't be that bad.

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By Kim Korth, President, IRN, Inc. [e-mail]