Four Truths About the Automotive Industry (part 2)

By McKinsey & Company | 20 January 2005

The global automotive industry has always been fascinated by the latest trends, but this focus on novelty may have led it to ignore - to its great peril - more fundamental realities. This paper, written by Glenn Mercer (NA) & Andreas Zielke (EU), McKinsey & Company, is exclusive to just-auto and highlights what they see as 'four truths' about the auto industry. It has been published in two parts (part one was published last week). Part two - reproduced below - examines the third and fourth of their four truths: 'a mid-market squeeze is on' and 'past trumps future'.

To read the first part of this paper which examines the first two of the 'four truths': 'the false promise of global convergence' and 'we must value the invaluable', please click here:

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More and more the automotive industry faces a situation in its most important markets not unlike other consumer goods: a sharp division into two segments that show markedly different characteristics and follow distinctly different business models - a "low end" defined by utilitarian concern for basic needs and a "high end" driven by luxury and branding. Where these two worlds appear to meet and overlap the principles for success become muddled. This middle ground, where in earlier times the marketers found the mass of their customers with neither high price sensitivity nor discerningly refined needs, this average that once required no specific skills to serve other than a reasonable command of industry standard best practice, this reliable volume base and provider of stable utilization is coming under increasing pressure, is currently suffering, and may ultimately disappear.

One should note that the mid-market in this sense is not defined by price alone but rather by the positioning OEMs choose for their product offerings: both expensive and inexpensive segments can have low, medium, and high-positioned products. Some OEMs will base their strategy more on the differentiation of their products from those of their competitors; some will focus on suggesting to customers that they offer the most value for money in whatever demand segment they are serving. Both strategies occur at low as well as at high price points. The Mercedes smartĀ© two-seater for example is certainly not a value-for-money type product although it is offered at a comparatively low price point, but rather emphasizes strongly its differentiated characteristics. The Ford Taurus on the other hand is much more expensive at least in absolute terms than the smartĀ© but it is positioned as the product of choice for a more price-sensitive clientele. The mid-market as we define it comprises all those products that lack a sharply defined positioning as either following the "high excitement" differentiation path or the "high value" paradigm.

Typically these mid-market products try to appeal to the greatest possible number of customers, and hence represent the lowest common denominator across a wide array of different customer profiles. They face the inherent risk of being in the initial set of considered choices for everyone, but the ultimate best choice for no one. Increasingly then the true reason-to-buy for such products moves away from the product itself and is substituted for by aspects such as prices, discounts, financing terms, and service levels. This mid-market therefore is home to the highest rebates and discounts and is heavily influenced by short-term goals without much concern for long-term utilization of highly specific dedicated assets like the ones typically found in production plants. The recent developments in the U.S. market illustrate this trend very well.

As a consequence there are two basic strategies to pursue for the individual auto maker, regardless of product segment: one aimed at providing high value and one aimed at providing high excitement. Naturally they will each have very specific prerequisites: the ability to continuously innovate and handle the ensuing complexity throughout all steps of the value chain will be more important for the high-excitement firm, whereas the discipline to execute standardized best-practice processes with as little variation as possible will be decisive for the high-value positioning. Tinkering with the product for minute improvements is permissible in the first context but not in the second. Being a fast follower goes well with the latter, but doesn't sufficiently support the prior. Since the respective skill requirements show so little overlap it is difficult for any one organization to simultaneously align itself against both of them with any degree of balance. Not only will this affect all steps along the entire value chain but also the value chain itself will have a different architecture depending on the segments served. For example, the benefit (or lack thereof) of owning retail outlets or using contract manufacturers will depend greatly on the underlying strategy being pursued.

Suppliers will be exposed to similar issues. While they are more remote from the customer interface, they still have to choose between betting on their ability to differentiate, or aspiring to provide the goods as specified at the lowest possible cost. And they will find the combination of both competitive paradigms just as difficult to implement as their OEM customers.

To avoid being caught in the mid-market squeeze auto makers (and some of their suppliers) need to face up to its organizational implications. They need to create organizational cells that are geared much more explicitly towards a single purpose: either contribute maximum differentiation or deliver the undifferentiated as efficiently as possible. Not all cells in their organization need to adhere to the same principle, but in most cases they ought to be aligned to either one or the other. All too often we encounter organizations in the automotive industry whose individual cells are left to find their own trade-offs between the two conflicting paradigms, often leading to rather junior personnel being shouldered with the most profound choices about the actual strategic profile of the company. While at the very top this creates the false impression of a uniform culture throughout, it leads to a dangerous tendency to favor the doomed middle ground down below. Rather we would suggest deciding the most difficult trade-offs on the highest hierarchical levels and then guiding each cell through a small set of simple rules imbuing it with a clear sense of direction.

The demise of the mid-market position spells the end to all notions of "combining the best of both worlds" in the automotive arena. Auto mergers aimed at creating efficiency-leading luxury brands the well-differentiated cost leaders by combining both characteristics under one roof have spectacularly underdelivered on their promises. Companies in the automotive industry must realize that they need to pick one path to glory - and then stick to it, patiently honing their organizational capabilities to its specific requirements. Rigorously assessing their starting position and avoiding the pitfalls of unreflected preferences for either mass or class industry leaders can create significant value. Winners will develop a much clearer idea of what type of competitor they want to be.


For the longest time it has been understood that the valuation of a company in the stock market is driven primarily by expectations regarding its future profits. It is not accumulated assets nor yesterday's performance per se that impress investors, but the prospect of continued attractive returns for those committing their money today. Of course, asset substance does enter the picture a bit because it could be liquidated and paid out to shareholders eventually. Past performance similarly is not completely irrelevant as investors find that it offers indications as to likely future strengths and weaknesses of the company in question. In summary, however, the share price generally reflects expectations of the future and not knowledge of the past.

The automotive industry has for many years consistently underperformed other industries in comparison to various capital market benchmarks. Its lack of attractiveness is mainly attributed to its inability to credibly generate high expectations as to its collective future profit potential. This is odd. Huge parts of the world's population aspire to own a car one day. Those who do own cars already dream of more expensive cars and some own several already. The automobile in addition is a product that lends itself like few others to being priced "emotionally" and made to carry significant intangible benefits in a way that allows extra margins. There is without any doubt considerable room for additional value creation.

Still, the share price of most automakers won't move, and is low on a per customer basis. Several OEMs have responded to this by attempting to increase their share of wallet with customers by expanding their reach into a broad field of downstream activities, including service and repair, financing and insurance, and even driving schools and scrapyards. None of these strategies has yet yielded compelling results, many have since been abandoned, and some have been quite costly to reverse. All have failed to substantially alter the capital market's perception of their future earnings potential.

There are at least two possible reasons for this astonishing lack of attractiveness. First, it may be that the car companies are not fully exposed to the discipline of the capital markets, and therefore do not feel compelled to generate returns in excess of their cost of capital: in fact, they may see their true cost of capital as lower than the market would calculate. Secondly, it may be that the auto makers and their suppliers do indeed create value in excess of their cost of capital, but find it difficult to retain that value (and thus share it with their shareholders): rather, other constituencies such as their own workforces or their own dealerships may be siphoning off more than their "fair share" of value generated. We can look at each of these hypotheses in turn.

The first is a hypothesis advanced by some researchers affiliated with the CoCKEAS1 program of a few years back. They wondered, as many of us do, how the OEMs could as a group produce returns to capital well below the cost of that capital for so many years. This would seem to be a state that could not persist, such that the researchers were puzzled that more capital had not exited the industry. However, upon investigation one sees that a great deal of the capital tied up in the OEM side of the business is capital on which a full and fair market return is not required. The Ford family exercises a good deal of control over Ford, the Quandt family of course has BMW, Lower Saxony has a special relationship with VW, and the Peugeot families and the government of France are involved with PSA and Renault. In these situations it is not that the owners seek out a below-market return, only that they may have different goals for their investment (e.g. preserving jobs, preserving the family fortune, playing a "white knight" ownership role) that could result in acceptance of such a return.

1CoCKEAS = Coordinating Competencies and Knowledge in the European Automotive System.

In other cases there is corporate partial ownership of a firm that forces a "control discount" on the remaining shares (e.g. Mazda under Ford control) or interlocking shareholdings that make a true assessment of capital risk murkier (see for example GM's holdings in Suzuki, Fuji, and Isuzu). Finally, there is an enormous amount of free or almost-free capital handed out to the OEMs by governments around the world, most often in the form of plant investment incentives, in many cases exceeding $200 million per factory, driven by the political urge to generate employment and a local industrial base. When a new plant costs an OEM half or less of what the true outlay would run, returns on that plant can be half or less of what the market would normally demand. Some observers would go so far as to call Japanese government intervention in the currency markets, which results in a cheap yen, a government subsidy benefiting primarily the automotive and consumer electronics industry. Finally, it should be pointed out that even when one or more players may receive no direct capital support at all - fully traded shares, no currency shield, no help with investments - they still are impacted by this phenomenon, to the extent that they have to deal with rivals who do receive such aid. Thus the impact of capital shielding affects all companies in the market.

Of course no one is asserting that this lack of market discipline translates explicitly into OEM decision-making: we are sure no Board of Directors says to itself "We don't have to make much money on the new Model X because we hardly paid anything for the factory that builds it." However, indirectly and over time the factors listed above add up to an insulation of OEM management from market forces that might not be tolerated in other more exposed industries, such as consumer electronics or grocery stores. There is some anecdotal evidence that this is the case, in that from time to time a carmaker executive will make off-hand remarks about the shareholders having to "wait their turn" in terms of value creation. If this hypothesis is indeed true (and proving it would be no easy task), then the implication for management is that they themselves need to step up to the challenge of recreating the market pressure internally where less exists externally. We realize that more pressure on these beleaguered companies might be hard to imagine, and we don't wish to make any manager's life even harder, but taking a fresh look at the earnings-generation capability of a car company, from the bottom up and with all capital being due its fair share of returns, then some decisions about growth, mergers, globalization, and market share might be made differently than they have been to date.

As to the second hypothesis, the jury is not still out in this case: it is very clear that entities around and outside the car companies do indeed retain much of the value that the car company brings into existence with the production and sale of a new car. As one automotive CEO famously observed: "Here's how Detroit works: we make cars, everyone else makes money!" These other constituencies can lay rather powerful claims on the potential profit streams and siphon off excess rents before the remaining value ever reaches the OEM's bottom line. The automotive suppliers are for example one class of stakeholders who could - through the prices of their parts and components and by capitalizing on OEMs' dependence on their contributions - potentially capture more than their "fair" share of industry profits. The record of those suppliers who are publicly quoted companies, however, offers little indication that they register significantly higher profits consistently. The OEMs' purchasing approaches have generally been sufficiently refined to by and large level the field in this regard.

Without question one of the most powerful among these stakeholders is the company's workforce - both present and retired. On this last point witness the fact that Ford last year paid out a higher share of its health-care cost to retired workers than to those actually still employed with the company. Automotive employment, particularly employment in manufacturing, is a hugely important political factor in practically all national economies with indigenous car making activities. Historically workers in this industry have been well organized and have accumulated formidable bargaining power. Over time heir unions won series of concessions that make jobs in this industry rather desirable in terms of pay and benefits as well as working conditions and protection against lay-offs.

These achievements have taken forms that not only affect the current cost of labor but also created obligations for future payments whose cost impact and true economic value was unknown at the time they were granted and in many cases still is uncertain today. Health care benefits in the US are a most significant case in point here, but other provisions in other countries have similar effects on car makers' strategies. To give away such future benefits was of course often very tempting, as it's their cost impact would not become apparent for some time and could be veiled by less than strict accounting rules. While individually still manageable the combined and compounded effect of such concessions over a prolonged period of time could ultimately become disastrous and practically eliminate many of the degrees of freedom for the current generation of decision makers.

In that sense the legacy of past decisions may actually assume an importance for the company's ability to create value that significantly exceeds the potential of all future decisions. The past and how it is being dealt with may thus quite rationally attract far more management attention than the future and what options it holds. Hence, it may be the ability to revisit the past, and re-interpret commitments, and thus gradually win back long lost degrees of freedom, that the markets should value, not the ability to give rise to new expectations beyond what could have been known already. This shift in focus is, however, not adequately reflected in how companies in the automotive industry are being directed, monitored, and reported on. Again, we believe that those players who quickly adopt a perspective that properly accounts for such legacies and guides their problems solving accordingly stand to reap considerable competitive advantages over their peers who still screen the horizon for the next growth opportunity without recognizing that the burden of their very own history will never let them get there in the first place.

Expanding the automotive industry's strategic discussion to explicitly include the forces described above will allow a fresh look at many of the issues that we have been hearing about for so long without getting any nearer to a compelling solution. It will also serve to reinforce the need for new tools and instruments, processes and skills to adequately address and deal with the underlying problems, thus promoting renewal in a far more substantive way than we have witnessed for many years. It may be the one opportunity for the industry as a whole to lay the foundation for another era of innovative leadership and attractive value creation.

Glenn Mercer
Andreas Zielke
McKinsey & Company
January, 2005

Readers with comments or questions are invited to contact the authors at glenn_mercer@mckinsey.com and andreas_zielke@mckinsey.com