Fitch: U.S. Auto Market Headed for Turbulent 2007.

CHICAGO -- The U.S. auto market experienced wrenching changes in 2006, and Fitch expects more of the same for 2007 and 2008 as Ford and General Motors (GM) proceed with restructuring plans in the midst of weakening economic conditions. Although significant restructuring actions have been announced, Ford and GM are still in the early stages of implementing these plans. Negative cash flows are projected to continue at both companies through 2007 due to continued share losses, restructuring costs and working capital outflows. Liquidity at Ford and GM, supplemented by recent financings and asset sales, is adequate to finance negative cash flows and should allay any liquidity concerns in 2007. The stresses to the supply base and the UAW contract re-opening in September 2007 also highlight event risk that will continue to plague the industry. The September 2007 contract negotiations with the UAW will be a pivotal event in determining GM, Ford and Chrysler's ability to establish a competitive cost structure sized to the companies' shrinking share and near-term revenue expectations. Operating challenges will also include significant changes to the workforce resulting from the massive buyout programs at Ford and GM. Legislative initiatives are also expected to have a higher profile in the industry in 2007 as a result of the change in power in Washington, although the impact is not likely to be felt next year.

Fitch has projected U.S. GDP growth of approximately 2.4% in 2007, as the weak housing market and high fuel prices squeeze consumer discretionary spending. Fitch projects that slower economic growth will lead to a 1.8% decline in domestic light vehicle sales from a projected 16.4 million vehicles in 2006 to 16.1 million in 2007. A portion of this decline can also be attributed to production cutbacks at the domestic manufacturers as they shrink unprofitable production geared to daily rental fleets and attempt to move away from ruinous cycles of over-production and heavy incentive programs.

Weakness in the housing market will continue to take a toll on pickup volumes and pricing, which will be a harsh impediment to turnaround efforts. Full-size pickup trucks remain a critical portion of consolidated volumes (27.6% of Ford's U.S. light vehicles sales first 11 months of 2006, 22.3% of GM, 17.0% of Chrysler) and an even higher contributor to profitability. This segment has suffered a 9.2% decline in unit volumes through November 2006, but has likely not yet absorbed the full brunt of the decline in residential construction. Volumes and pricing are likely to be especially affected at Ford and Chrysler with the launch of GM's new trucks and the start-up of Toyota's new pickup plant.

Outside of pickups, Ford, GM and Chrysler will continue to suffer from product mix imbalances as they remain overexposed to the mid-size and large SUV markets. Demand in these segments continues to decline, although the impact on consolidated results has diminished since further declines are coming off a much smaller base, and production levels are being adjusted. Ford, GM and Chrysler remain under-represented in passenger car and crossover segments, and the mix imbalance will be exacerbated by the continuing expansion of Toyota, Honda, Nissan, and the Hyundai Kia Automotive Group. Each of these manufacturers will be steadily increasing capacity through the end of the decade, largely in the segments of the market where consumers are migrating. Even if Ford and GM are able to launch successful products in this end of the market, reaping sustainable profitability at lower price points will be a challenge, as an uncompetitive cost structure will remain a hindrance.

The production advantages enjoyed by the transplants - platform extensions and parts commonality, flexible manufacturing facilities that allow quick product transitions and switching production between plants - provide a significant advantage in terms of cost, capital investment and quality. However, the decline in U.S. sales by Nissan in 2006 demonstrates that even the transplants are not immune to product cycles. Perhaps more interesting has been the higher level of recalls by Toyota, Honda and Nissan over the past several years, and to observe whether this continues and starts to affect the brands. Domestic manufacturers continue to close the quality gap, although consumer perception has lagged this progress.

Although GM and Ford have not made significant progress in reducing their overall reliance on fleet sales, they have improved the management of sales to daily rental firms through production cuts on unprofitable vehicles and better pricing. The transition to value pricing at the dealership level has been promising, as the OEM's have taken more aggressive action on cutting back production. To date, this has resulted in lower incentive levels in 2006. The combination of more profitable daily rental sales, value pricing and enhanced warranties could further improve residual value performance and brand perception at GM and Ford.

Sliding market share at Ford, GM and Chrysler will continue as they shut down capacity in the face of concurrent capacity expansion by transplants. As a result, any return to profitability by domestic manufacturers over the next several years will have to be derived largely from significant improvement in their cost structures. This is not expected to be accomplished in 2007 and negative cash flows are expected to persist next year for Ford and GM.

September 2007 UAW Contract

The talks with the UAW are expected to be contentious, and a labor action cannot be ruled out. In effect, the contract talks have been open for some time with significant steps having been taken in the areas of UAW buyout programs, health care agreements, Delphi and Visteon developments, and factory-floor level changes to job classifications, work rules, etc.

The most contentious issue is likely to be that of health care, with Ford spending approximately $3.5 billion in 2005 and GM spending approximately $5.4 billion. Other expected topics include the jobs bank, the ability to outsource labor and production, flexibility to shut down plants, wage levels (including two-tier wage structures), work rules, and job classifications. and more. Pensions are expected to be a secondary issue in the current contract talks due to the funded status of U.S. plans, although over the longer term, as is occurring throughout corporate America, the auto makers are expected to try and transition these plans to a defined contribution structure.

The contracts that the UAW has in place across its membership vary significantly, with the U.S. automaker contracts ranking as the most expensive and inflexible. Caterpillar, Deere and a number of auto suppliers have UAW contracts with a range of more favorable terms, from tight limitations on retiree health care, two-tier wage scales, etc. Due to the current financial and operating stress at Ford and GM, the OEMs are likely to view the upcoming talks as a timely and imperative occasion to seek reductions in wage and benefit levels. Delphi is a case study in the potential rapid transition from one end of the contract spectrum to the other (although Delphi workers retain the support of GM's guarantee to safeguard retirement benefits) and provides a glimpse of the complexity and challenges of the upcoming negotiations. Fitch expects that over the intermediate term, health care liabilities will continue to be ratcheted down, through contract negotiations or through a more contentious route.

Pension issues are expected to remain a back-burner issue for Ford and GM, due to 2006 asset returns and the lack of required contributions over the near term. Structural changes to retirement programs and greater retirements will alleviate the growth in potential liabilities, although the substantial growth in new retirements resulting from the buyout program will augment already high payouts, primarily at GM. Over the longer term, Ford and GM remain exposed to periodic declines in pension asset returns, such as in the 2000-2002 period, which could result in increased claims on cash flows. International pension plans remain largely underfunded, representing an ongoing cash burden.

The UAW negotiated health care agreements with GM and Ford at the end of 2005 but has initially rejected an agreement with Chrysler in September 2006. In 2007, Chrysler is expected to suffer operating losses as a result of the same factors that are plaguing GM and Ford - a weakening economy, declining share and revenues, mix issues (including a deteriorating pickup market), a high cost structure, health care costs, etc. However, DaimlerChrysler has a far stronger global operating and financial profile, and the UAW may, in effect, attempt to force DaimlerChrysler's non-Chrysler operations to subsidize the high cost structure at Chrysler. It will be interesting to watch whether this represents a potential break in the historic pattern bargaining that has taken place between the UAW and the auto makers. As the financial positions of Ford, GM and DaimlerChrysler have diverged, the needs of the OEMs in contract negotiations with the UAW agreement may also diverge.

The UAW may also keep potential alliances in mind during the negotiations, as North American UAW plants and labor would not likely fare well in any global capacity realignment undertaken by a large-scale GM or Ford tie-up with an international partner(s).

Supplier Stresses

The stresses in the supply chain will continue throughout 2007, as lower production from domestic manufacturers, pricing pressures and high commodity costs prevent any significant improvement in operating results or financial position. As with the OEM's, suppliers are also in the midst of a multi-year restructuring program that includes major workforce reductions, wage and benefit reductions, and a relocation of the manufacturing base overseas. This could result in further supply-chain risk to the OEM's on both the operating side (through potential supply disruptions) and the financial side (through higher costs or financial support). Event risk will take a number of forms including labor issues (Delphi, Goodyear) or pricing disputes between suppliers and OEMs. The geographic stretching of the supply chain also poses a higher risk of supply interruptions over the longer term. Unrelieved stresses in the supply base in 2007 and a hesitancy by OEM's to grant long-term contracts to suppliers in weak financial condition are expected to lead to more bankruptcies over the intermediate term. Suppliers have taken advantage of accommodative loan markets to shore up liquidity, but attractive market conditions may not persist and supplier balance sheets at the lower end of the credit scale are not expected to show improvement in 2007.

In addition to the challenges posed by the supply base, Ford and GM face a daunting operational task as they integrate massive changes in the composition of their manufacturing workforce (retirements, job transfers, and temporary workers), changes to purchasing processes, incremental flexibility to manufacturing operations, and accelerating new product launches and refreshenings. These efforts put at risk recent gains in efficiency and quality that the domestic manufacturers have been able to achieve and could threaten their ability to narrow the gap in these areas versus transplants.

Alliances

Potential alliances received a lot of attention in 2006, but major tie-ups along the outlines of the Renault-Nissan-GM discussions are unlikely in 2007. Alliances are likely over the long-term, if for no other reason than to compete more effectively against Toyota on a global basis. The efficiencies and cost savings from purchasing, engineering, platform sharing and global parts commonality are too attractive to ignore as shifting global production patterns (largely to China and Eastern Europe) continue. In addition, alliances are likely to be critical to constraining global capacity growth over the long term - to prevent industry over-investment and subsequent shakeouts, as may eventually play out in China. However, for the domestic manufacturers, the benefits of potential alliances are likely to be far in the future and will do little to address the immediate problem of turning around their North American operations. In addition, the alliances are unlikely to be cemented until the new UAW contract talks are completed, as international alliance partners would want to gauge the flexibility and cost competitiveness of North American manufacturing operations, as well as the financial heath of the domestic manufacturers, prior to any agreement.

Legislative Agenda

The change in control of the House and the Senate could also bring legislative initiatives to the forefront in 2007, although the impact from any new legislation is not likely to be felt next year. A more union-friendly legislative environment and initiatives in the areas of higher fuel-economy standards, other environmental topics, and safety issues could have a negative impact on the domestic manufacturers. Tax incentives on hybrids or other fuel-efficient vehicles, or gas-guzzler taxes, could also have on impact on segment volumes and industry mix. Legislative initiatives that could benefit the OEM's could include changes to the health care system, funding assistance for fuel-efficiency or environmental investment programs, and tighter trade controls. It is also important to note that the automotive industry no longer speaks with one voice from Detroit, due to the geographic dispersion and representation of transplant manufacturing operations.

Liquidity

Through asset sales and new financings completed in 2006, Ford and GM will enter 2007 with substantial liquidity to tackle their restructuring efforts. Ford has estimated that cash outflows during 2007 and 2008 are estimated at $17 billion, including $7 billion of restructuring-related outflows. It is expected that Ford will complete the sale of Aston Martin in 2007, although other asset sales at Ford are expected to be limited. The hourly workforce buyout program is comparatively more expensive at Ford than at GM given its younger work force, but Ford's statement that more than half of the departures are with packages that do not include retiree healthcare will be a meaningful savings for Ford over the long-term.

GM is also expected to be cash flow negative in 2007, although to a lesser degree than Ford due to the fact that substantial restructuring costs related to buyout programs are taking place in 2006. In 2007, GM will benefit from the shipment of new pickups to dealers, but the combination of slower economic growth on other market segments, cost pressures, continued restructuring costs, working capital outflows, a $1 billion independent VEBA contribution arising from the UAW healthcare agreement and the costs of resolving the Delphi situation are expected to result in continued negative cash flow. The SUV and new pickup introductions will continue to support revenues through the first half of 2007 but are likely unsustainable given trends in the SUV segment, high gas prices and weakness in residential construction.

The international operations of Ford and GM provide limited resources with which to aid the turnaround of North American operations. International operations of Ford and GM have shown a degree of stability and growth, but marginal profitability and global competition indicate that these operations may remain sources of potential risk through product and economic cycles. In China, rapid growth has been matched by high reinvestment requirements, providing limited opportunity for these operations to repatriate funds or enhance consolidated liquidity.

More so than in the recent past, new product pipelines among the major global competitors highlight different philosophies and investments regarding the direction of future technologies. From different hybrid technologies, to politically-popular ethanol, diesel, diesel hybrids, plug-in vehicles and eventual hydrogen fuel cells, multiple paths are emerging. Although product and investment spending have been sustained at Ford and GM over the past several years, the companies are clearly capital constrained versus the transplants (and DaimlerChrysler), which certainly pose long-term risk in an industry where technology and innovation are imperative.

New Product Pipeline

In 2007, GM will be the best positioned domestic manufacturer from a new product standpoint, particularly with the rollout of its refreshed pickup truck lineup, new cross utility vehicles, and almost completely revised Saturn lineup. The success to date of the GMT-900 series of products indicates that although this segment of the market continues to shrink, GM is expected to hold its strong leadership position within it with the launch of the new Chevrolet Silverado and GMC Sierra. The new GMC Acadia, Saturn Outlook, and Buick Enclave cross utility vehicles are expected to eventually replace GM's aging minivans, mid-size SUVs (excluding the Hummer H3) and the Buick Rendezvous. Saturn's new lineup including the Sky roadster, Aura sedan, Hybrid Vue, Outlook CUV, and most likely re-bagged Opel Astra could revitalize the brand. Other notable launches include a new Cadillac CTS, 2-mode hybrid versions of the Chevrolet Tahoe and GMC Yukon, and new Chevrolet Malibu that shares the same epsilon architecture as the Aura and, like the Aura, will have an optional hybrid system.

The reception afforded to GM of these new vehicles and hybrid systems could serve to improve GM's consumer image. GM's financial results in the first half of 2007 will benefit most from the rollout and shipment of their refreshed pickup lineup, but the sustainability of these sales throughout 2007, given weaker economic conditions, is uncertain.

Ford's relatively modest product introductions for 2007 include new cross utility vehicles, recently launched new large SUVs, and redesigned Super Duty pickup trucks. Similar to GM's strategy, the new Ford Edge and Lincoln MKX CUVs are expected to replace sales from the minivan segment that Ford is exiting. Ford is also launching new versions of the Ford Escape and Mercury Mariner hybrid and non-hybrid CUVs. In the shrinking but still profitable full size SUV segment Ford has recently launched a new Ford Expedition and Lincoln Navigator to compete primarily with GM's Chevrolet Tahoe, GMC Yukon, and Cadillac Escalade. Ford's new Super Duty pickup trucks offer a new 6.4-liter diesel engine that should help keep these products competitive.

Ford's Premier Automotive Group launches in 2007 include a Volvo C30 Hatchback and Land Rover CUV called the LR2. Land Rover notably is the only Ford brand that has grown its sales in 2006 through November. Ford has shown strength in its passenger car segment, with the relatively new Ford Fusion, Mercury Milan, and Lincoln MKZ (originally introduced as the Zephyr) receiving top predicted-reliability ratings from Consumer Reports. Hybrid versions of the Fusion and Milan are expected in 2008. Overall 2007 will be a difficult year for Ford's sales. Without the Ford Taurus (which remains Ford's best selling car through November 2006), pressure on its pickup truck volumes, and continuing erosion in the SUV segment indicate that Ford's market share will continue to deteriorate. Ford projects its market share slipping to the 14%-15% range in 2008, which will be below Toyota.

DaimlerChrysler has the most extensive set of full product introductions, but will be hard-pressed to limit share losses due to having the heaviest concentration in the truck market among the domestic manufacturers. For 2007 the Chrysler Group's most important launches will include its redesigned minivans, several CUV introductions, new midsize cars, and an almost entirely refreshed Jeep lineup. The combined sales of the Chrysler Town and Country and Dodge Caravan minivans represent the Chrysler Group's highest sales volume product. The Dodge brand is likely to receive two new products in addition to the minivan, the Nitro which is in the midst of a launch and the Avenger sedan that will replace the Stratus. The Chrysler brand, in addition to receiving its new minivan, will receive a new Sebring sedan and convertible. The convertible will be available with either a soft-top or hard-top configuration. Jeep, similar to GM's Saturn division, is undergoing a product renaissance and in 2007 will have several new CUV and SUVs including the Compass, Patriot, Wrangler two- and four-door, new Liberty, as well as a Grand Cherokee that will offer a Mercedes-Benz engineered diesel engine.

Mercedes' redesigned E and S classes are expected to continue to do well into 2007 along with the redesigned C class. The Smart fortwo is not expected to hit the U.S. until 2008. Generally, it will be difficult for DaimlerChrysler's new product offerings to be sufficient to offset its exposure to its SUVs and pickup trucks. The Dodge Ram sales and/or profitability are likely to be affected by the new GM and Toyota full size trucks.

In summary, 2007 is likely to be dominated by three areas - the extent of economic weakness, progress on restructuring programs, and the UAW contract. At year-end 2007, the competitive position of Ford and GM will be shaped by the terms of a new UAW contract and their ability to realize structural cost reductions in the midst of a major repositioning of their assembly operations. Liquidity is certain to be reduced from year-end 2006 levels, and could be further affected by any labor action associated with the UAW negotiations. Revenues will remain under pressure throughout the year, and 2008 will bring more of the same due to plant closures and restructuring activities. By the end of 2007, significant competitive disadvantages will remain, but Ford and GM should be farther along in attempting to regain a competitive cost structure. In addition, the product pipelines at Ford and GM should more closely align market demand, getting farther away from the over-exposure to SUVs that did so much damage over the past several years.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.