The U.S. economy has never looked stronger.
It has been powerful enough to pull Asia out of its recession, has fueled growth in Europe
and stabilized the economies of South America. The Federal Reserve’s pre-emptive rate
hikes, designed to sacrifice short-term growth spurts in the interest of a longer,
smoother, more sustainable recovery, have worked: the economy’s growth rate has
decelerated while the expansion moves toward an all-time record for longevity.

manufacturers have been one of the prime beneficiaries of the roaring economy, enjoying
record-breaking vehicle sales and profits. But they realize that after ten years the
economy may slow down or turn negative, because what the consumer sector giveth it
inevitably taketh away. So far, American consumers have performed heroically, taking the
world economy on their well-padded shoulders by buying so many imported goods that the
U.S. trade deficit hit new records in each of the last seven months.

In fact, American consumers have been
spending more than they make: consumer confidence has out-paced personal income, because
of the “hidden” wealth probably caused by the other record performer lately —
the stock market. Stock market winnings, which most analysts believe is fueling the
spending spree, aren’t counted in personal income statistics, but economists are sure they
count in the “wealth effect” that drives consumer spending. Therein lies the
risk to the economy: should the stock market bubble burst, it dissolves the wealth effect
and devastates consumer confidence.

It is that eventuality that all
consumer-driven industries — but especially the auto industry — must take into account
in their risk planning. Not only are vehicle manufacturers and suppliers the first in and
the last out of a recession; by their very structure they cannot make rapid adjustments to
economic changes. High fixed costs, and foreign much less nimble than most industries when
spending falters.

industry needs to spread its risk. Facing the low-growth, low margin markets in the
industrialized markets, VMs see investment in emerging markets, including those in
Asia-Pacific, East Europe, South America, Africa and the Middle-East, offering the
greatest potential for growth and opportunity — through increased product offerings,
regional population demographic changes and, in fact, plenty of room for economic growth.

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Our forecasts indicate that over the next
five years, the biggest contribution to growth in automotive markets will be in the
Asia-Pacific area, with almost half the growth share. East Europe will be next highest,
with 16%. Of course, these emerging markets also carry the highest risks, subject as they
are to economic and political instability. (However, within each area the range of risk is
enormous: our forecasts indicate that auto markets in Brazil and India, for instance, will
develop lustily, but Spain and Venezuela will be serious underachievers.) With most of the
growth coming from the developing world, mature auto markets, especially in a period of
record profits, are becoming cash cows, generating the money necessary for investments
where the growth potential is much greater.

Vehicle Manufacturer’s Gross

As both VM and supplier companies expend
financial resources to expand into emerging markets and sustain market share in mature
ones, they walk a fine line to hedge risk yet increase shareholder value. VMs have tried
for years to minimize their own risks by demanding annual costs cuts of 1%-3% from
suppliers. Now, with returns on sales still hovering between 3% and 5%, they must examine
new cost-cutting measures to assure long term growth and reduce the risks associated with
a recession in any — or all — of their markets.

MODULE CARS. Much in vogue
with VMs now, especially GM, is modularization, which enables VMs to reallocate assets —
not to mention roles and responsibilities — to suppliers, who are now expected to
shoulder more of the R&D, manufacturing, assembly and delivery of major
“chunks” of the vehicle. Of course, as more responsibility is shifted to
supplier companies, VMs will be able to realize serious cost savings. The average wage
(before benefits) for an assembly-line job at one of the former Big Three is $21.00 an
hour; the same wage at a typical Tier 1 supplier is $13.00. (However, the risks involved
extend beyond cost savings and into the impact on union relations and future

With modularization comes an increasing
emphasis on globalization, since supplier companies must now become international, tying
together multiple engineering, R&D, assembly and purchasing operations for customers
in multiple markets. Suppliers are being pressured to relocate (or expand) from mature
markets — through joint ventures, alliances and mergers — to emerging markets where
their VMs assemble vehicles. In doing this, suppliers find not only new risks — including
unstable economies and uncertain political futures — but that the suppliers already
established in those markets enjoy serious competitive advantages.

Vehicle Manufacturer’s Gross Profit

Modularization is the vehicle
manufacturers’ answer to risk. But what about suppliers? What measures will they take to
reduce the risks of an economic downturn? At present, the three leading contenders can be
summed up as: integrate, consolidate, regenerate.

1. Integrate.

Suppliers will seek closer integration and
interdependence between themselves and VM customers through the use of technology-driven
solutions — e-business, CAD, CAM, CAE and on-line bidding.

Through systems integration, modularization
and globalization, supplier companies can spread the risks associated with entering an
unfamiliar market(s) with a partner(s). As suppliers take on non-traditional
responsibilities, they need to imitate their VM clients, adopting lean manufacturing and
resource management techniques. In the late 80s consulting services offering auditing,
management strategy and IT solutions were used by VMs to boost productivity, improve brand
management and vehicle sales with cost cuts and boosts in operational efficiency. These
consultants will find that a rapidly consolidating supplier industry offers abundant

But while some of the technology-driven
solutions for suppliers will come from outside consultants, it is important that the
knowledge transfer also come from or through the VMs themselves. By working together in a
partnership, sharing the manufacturing and supply-chain knowhow, VM and supplier companies
can better sustain growth in an economic downturn by discovering innovative and
cost-effective methods of manufacturing, marketing and selling vehicles.

One model many supplier companies will
consider using is General Motor’s “e-GM” which will allow it to use the net for
everything from parts sourcing and bidding to auto retail and leasing. Over the next five
years GM expects to cut up to $600 million per year in costs, from engineering and design
to retail and leasing. e-GM is also expected to be the growth engine for the company’s
OnStar system, expanding that system’s subscriber base from 75,000 now to one million by
the end of 2001, adding two million more each year after that. One supplier already
applying the model is GM’s former captive, Delphi Automotive Systems, which is adopting
some of GM’s e-commerce objectives and strategies to cut costs, grow non-GM business
and in general increase its competitiveness globally.

2. Consolidate.

VMs are offloading more R&D, quality
control, manufacturing and cost management onto suppliers. For this to work, suppliers
must have the financial and technical resources to make it cost-effective.

Translation: supplier merger and
acquisition activity will continue to heat up. In 1998 there were 320 acquisitions and
mergers in the supplier industry worldwide, with an estimated value of $30 billion, nearly
double the value of the $16.7 billion reported in 1997. More importantly, the average
value of the ten largest deals more than doubled in 1998, from $800 million to $1.8
billion. As the pace quickens and transaction prices grow, the 1,500 remaining Tier 1
suppliers of 1998 are predicted to consolidate by 2005 into 600 major suppliers — 150
suppliers of integrated systems and modules, and 450 direct suppliers, who will still sell
parts rather than systems directly to the VMs.

Traditional Model: VMs Absorb Most
Costs In Top & Bottom Sectors

For the automotive industry as a whole, the
benefits of supplier consolidation lie in its re-distribution of organizational
responsibility, and the consequent lowering of costs throughout the automotive supply
chain. The cost savings will come from simplified and streamlined purchasing systems, the
elimination of duplicated assets and the design of global platforms to standardize parts
and processes.

For VMs, the big cost savings lie in the
potential for lower overhead, fewer workers, fewer parts in inventory and steps in parts
assembly, since bigger, more innovative suppliers mean that more of the VMs’ design,
purchasing and assembly can be outsourced.

For the suppliers themselves, the benefits
will derive from bigger contracts, which involve more product content, and the ability to
spread R&D, quality control and manufacturing responsibilities over the larger
resource base and geographic base that comes with having a large global company.

Modularization: VMs Absorb Mosr Top
Costs, Suppliers Bottom Costs

3. Regenerate.

Suppliers must help the entire auto
industry to evolve — from an industry that supplies parts, components or vehicles to one
which views itself as supplying transportation systems and solutions.

The more extensive alliances and
partnerships between VMs and their suppliers will provide both with greater economies of
scale, but also involve greater long-term financial risk during periods of economic
turmoil or rapid technological change. In order to better protect itself from the effects
of (a) a cyclical economy or (b) a technological revolution, the automotive industry is
slowly embracing the idea of providing entire transportation services and solutions,
involving what planners in the Eighties used to call a paradigm shift.

Ford is already embracing this philosophy. It recently purchased a junk yard to recycle
used parts, Kwik-Fit, Europe’s largest after-market parts distributor, and Visteon
bought Plastic Omnium, the European parts supplier. It has also arranged several minority
ownership agreements and joint ventures with satellite radio providers such as Matsushita
and CD Radio. It still maintains investments in Visteon and Hertz, and is expanding the
services offered by Ford Credit to include e-commerce.

Honda is preparing for the day when auto
sales can no longer be depended upon for the bulk of its revenue generation. Looking
beyond the auto industry, it is considering becoming a general transportation provider,
and actively exploring everything from commuter aircraft to advanced power generation

Among suppliers, Magna International, in its drive to grow its business and
diversify its product portfolio, is spinning its non-automotive business into a different
wholly owned company. In line with the wishes of its president, Magna has bought
racetracks, racehorses, casinos and an amusement park to hedge against cyclical risks.

Most VMs and suppliers are currently
following one of these business models. In its move to diversify, the automotive industry
is doing what the American railroad industry didn’t do. When first the automobile and then
the airplane captured train passengers, the rail companies persisted in seeing themselves
merely as providers of rail-based transportation, not as a provider of transportation
solutions, and fell victim to more convenient modes of transportation.

avoid the fate of the rail-road industry, and to hedge risks, lower costs and grow
revenue-generating options, both VMs and supplier companies are focusing on opportunities
outside, but still related to automobile manufacturing. Ford, for instance, wants to
reinvent itself into the world’s leading consumer company for products/ services
related to the transportation industry, and increase its “consumer touches”.
More suppliers and VMs are taking this view, trying to become “transportation system
support services”, and using acquisitions to gain size and knowhow.

The developing partnerships not only
diversify and expand product offerings but also involve companies in industries with much
higher margins and lower overhead costs than manufacturing operations. This difference in
investment and operational returns can help transfer risks in the event of a decrease in
sales or an economic recession.

industry as a whole must also pay attention to “threat technology” backed up by
“green legislation.” Both auto and oil industry have tried to plan for the day
when the internal combustion engine is replaced by the fuel cell. Prototype fuel cell
vehicles have already been manufactured by DC (the Necar IV) and Ford (P2000, a fuel-cell
equipped Contour). Both DC and Ford have JVs with Ballard Power Systems to design and
develop efficient and practical fuel-cell powered vehicles by 2003. Toyota and GM have
agreed to share the R&D to develop fuel cell technology and increase its practicality.
Honda, staying with its go-it-alone philosophy, has recently started an R&D division
solely to develop fuel cells for automotive, industrial and commercial applications.

Ike Anyanwu-Ebo, Kevin Armour, Ed
Martin, Joe McCabe, PriceWaterhouseCoopers