Car makers’ boom years deflate

DETROIT – This decade has already seen burst bubbles in tech stocks, homes and credit. Now, it seems, another segment has fallen victim to irrational exuberance: the U.S. auto market.

Like investors who sent dot-com stocks or house prices to unsustainable levels, auto manufacturers in the U.S. have pushed their sales volumes to new peaks over the past decade. They invited customers to buy cars at employee prices, extended no-interest loans for up to six years and sold unprecedented numbers of vehicles to rental fleets – all strategies that some analysts say drove U.S. auto sales to artificial highs.

Through most of the 1990s, auto makers sold a little over 15 million cars and light trucks a year in the U.S. market. That changed in the late 1990s: With gasoline prices low and many U.S. consumers feeling flush from the tech-stock boom, auto sales surged. Sales peaked at 17.4 million in 2000 and remained near 17 million for another five years. Heads of General Motors Corp. and Toyota said the U.S. was entering a golden age of the automobile. In 2003, Toyota’s head of North American sales predicted the industry would soon be selling 20 million vehicles a year.

They were wrong. Sales started falling in 2006 and this year are expected to be right back where they were in the 1990s, at just over 15 million. Last week, market researcher Global Insight Inc. lowered its 2008 forecast for U.S. vehicle sales to below 15 million. Global Insight now believes sales won’t reach previous highs again until 2012, a year later than it had previously thought.

”Going forward, 16 million is a good year,” says Ron Harbour, whose firm, Harbour Consulting, tracks auto production.

The industry’s miscalculations hold broader consequences for the U.S. economy. The auto industry is the nation’s largest manufacturing sector, accounting for almost 4 percent of U.S. gross domestic product. It employs about 2.5 million people directly or indirectly, and spends tens of billions of dollars a year in research and development.

Because auto makers have to project their model lineups and manufacturing requirements about three years in advance, a company that misjudges future demand can rack up big losses. The slump in auto sales is already complicating the turnaround efforts of the Big Three – GM, Ford Motor Co. and Chrysler LLC – and pinching the earnings of foreign auto makers including Toyota Motor Corp. and Nissan Motor Co.

A bubble occurs when market participants push prices of assets – stocks, homes, tulips – higher than their intrinsic values would appear to merit. While the auto-industry doesn’t fit the classic formula of an asset bubble, a similar degree of mania was apparently at work: Makers believed they could sell vehicles in much greater numbers than the market would ultimately bear.

GM spokesman Tony Cervone said the company didn’t overestimate demand and blamed the current sales slump on the U.S. economy’s slowdown. Earlier in the decade, he said, trends in household income and spending power all pointed toward steady growth. A Chrysler spokesman says the company sees long-term growth in the U.S., driven by its growing population and income levels.

The seeds for the boom were planted in 1999, when the stock market was roaring and Americans headed to showrooms to splurge on new wheels, often trucks. Gas at the time was cheap, about $1.15 a gallon.

A year later, the tech-stock bubble burst and the economy began to cool. After the attacks of Sept. 11, 2001, stunned consumers stopped shopping. Dealerships were empty. Hoping to help jump-start the U.S. economy, GM started a ”Keep America Rolling” sale, offering 0 percent financing for 60 months.

Sales took off again. Ford, Chrysler and other manufacturers countered with incentives of their own. By late 2002, many GM rivals were complaining the discounting was destroying profits for all players. GM Chief Executive Rick Wagoner offered a response at an industry conference in 2003: ”Stop whining and just play the game.”

The Big Three and a few other auto makers had also rediscovered another way to boost volume – selling to rental fleets. Each of the Detroit auto makers owned stakes in rental companies, and they pushed unsold cars on them at cut-rate prices. In 2005, for example, a quarter of all vehicles GM and Ford sold in the U.S. went to fleet customers.

The incentives race continued. By 2005, Big Three makers were offering as much as $8,000 discounts on some trucks. That summer, Big Three makers rolled out ”employee pricing” – allowing regular customers to buy cars at the same prices the Big Three offered their workers. Sales soared for a few months.

One critic of these practices was Michael J. Jackson, chief executive of AutoNation Inc., the country’s largest dealership chain. In interviews and speeches, he argued that heavy incentives and rental sales were unsustainable. Worried that sales would eventually fall, he also cut the number of vehicles AutoNation ordered from manufacturers.

This brought angry calls and emails from auto executives. ”They were saying, ‘You’ve completely misread the market,”’ Mr. Jackson recalled in an interview. ”But we were right.”

From one perspective, auto sales during the go-go years of 1999 to 2005 don’t appear inflated. Volumes remained steady, rather than spiking dramatically. But a closer look reveals an oddity: The economy slumped in 2001-02. ”We had an economic downturn and vehicle sales stayed near record highs,” says Ford economist Emily Kolinsky Morris. ”It was a very different industry dynamic.”

Automakers’ incentives were so enticing that people who weren’t quite ready to buy cars pulled their purchases ahead to take advantage of the deals. But that only turned future customers into present customers. When all those buyers are no longer in the market, sales dry up. The industry calls this ”payback.”

Two years ago, Ray Yacouby, a construction consultant in Acton, Mass., was content driving a 2000 Lincoln LS with only about 20,000 miles on it. But he was lured into his dealership by a cut-rate lease on a Zephyr sedan. ”It was all about the deal,” he said. ”I couldn’t pass it up.”

But the deals are often keeping customers from buying again, as Brad Wilson’s recent experience shows. In 2006, the 37-year-old plastics engineer in Saline, Mich., bought a $42,000 Chevrolet Suburban, receiving a five-year, no-interest loan from GM.

With gas now cresting $4 a gallon, he says it would make sense to trade in his big SUV for something that gets better mileage. But Mr. Wilson is ”upside down” – he owes more on the loan, about $24,000, than the vehicle is worth, $16,000. Short of defaulting on his loan, he’s stuck with the car. ”I’ll probably keep it for 10 years,” he says.

One measure, scrappage, suggests the new-car thirst has been mostly slaked among Americans like Messrs. Yacouby and Wilson. When a high percentage of cars are taken off the roads and scrapped in a given year, it indicates that consumers may be preparing to replace them with new ones. A low scrappage rate suggests a slack market for new cars. In 2001, scrappage was 6.8 percent, in line with historical trends, according to R.L. Polk & Co. In 2005, it fell to 4.3 percent, the lowest level since 1948. In 2007, scrappage rose to 5.2 percent, indicating it may take a few more years for pent-up demand to mount.

A slower-than-expected recovery is likely to compound the woes of the auto industry, which has already seen the Big Three report huge losses and slash tens of thousands of jobs in the last three years. The industry already has a glut of production capacity, which will be heightened as demand falls.

For years, auto makers have had too many North American plants, which puts downward pressure on prices. It has the capacity to make about 18.7 million cars this year, but is on track to make just 14.1 million, according to J.D. Power & Associates.

Over the past few years General Motors, Ford and Chrysler made plans to close several plants. But the industry’s capacity as a whole hasn’t really declined because foreign auto makers have been building new facilities.

In the next year or two, at least three new auto assembly plants are set to open in the U.S., all greenlighted back when sales were still surging. They include a Toyota plant in Tupelo, Miss.; a Honda Motor Co. plant in Indiana; and a Kia Motors plant in Georgia. Volkswagen AG is planning to name a site for a U.S. plant of its own this summer.

The new capacity – four plants can produce nearly one million vehicles a year – is likely to keep the Big Three under pressure to go beyond their current downsizing. ”There’s no doubt” that some North American plants will have to close as a result, said Mr. Harbour of Harbour Consulting.

The pressure will be most acute on truck plants, as U.S. consumers shift away from big gas-guzzlers. So far this year the auto industry is on track to sell about 500,000 full-size SUVs. That’s half as many as it sold in 2003, and enough to fill up just two plants.

GM alone has two plants making full-size SUVs. Later this year it will cut production at both plants as well as at two pick-up truck plants, leaving each operating a single eight-hour shift a day.

Foreign auto makers, which have rarely had to cut production or jobs at their U.S. plants, are acting as well. Until recently, Toyota had been ramping up truck production in North America on the belief that the U.S. market was headed for a long expansion.

But Toyota senior executives recently concluded it has about a full plant’s worth of excess capacity in North America, not including the Tupelo plant due to open in 2010. As a result, Toyota has dialed back the number of vehicles the Tupelo plant will make when it opens – to about 120,000 a year, down from the 200,000 or so that the company was envisioning in 2006, company officials said.

Koki Konishi, Toyota’s top spokesman in Tokyo, acknowledged the company is ”adjusting” its production plans, adding that there’s no doubt that demand will remain sluggish for the next couple years.

Nissan, too, has trimmed truck production at its plant in Canton, Miss., and reduced car and truck production in Smyrna, Tenn. The plants are working at about 65 percent capacity, Nissan Chief Executive Carlos Ghosn said in an interview.

”We are like anybody else who installed capacity for this market,” he said. ”We are underutilizing that.”