Sunday, November 16, 2008

Good companies in bad businesses

All this talk about a federal bailout of GM and Ford has started me thinking about something that has always bothered me. There are some businesses where even the best companies seem to barely make it and everyone else is under water. The automobile business is a good example. Take Toyota, a company that most analysts would consider to be the star of the sector. The company earned a return on capital that matched its cost of capital last year and that was a good year. If the best company in the sector breaks even in a good year, where is the upside in this business? The airline business, since deregulation, is another example of a business that has few profitable companies. I know.. I know.. There are Southwest and Ryanair, but even these paragons of corporate profitability earn returns on capital that trail their costs of capital. The rest of the business is a disaster.

I opened up my economics and corporate strategy books to see if I could find an answer. One possibility is that these businesses are filled with irrational companies that do stupid things over extended periods, but I find that hard to believe. The other is that these businesses have not found (or have lost) a structure that can generate profits on a sustained basis. In the airlines business, deregulation opened the business up to new entrants and the new firms that entered undercut the established competition with lower prices for the most profitable routes. In the automobile business, the problem seems to be legacy costs - c0sts that firms have piled up over time, usually in return for short term labor peace. Note that the older automobile firms are in the most trouble... those pension obligations that they committed to decades ago have come back to haunt them.

Eventually, these businesses will have to find a stable structure, where the companies at least on average earn their cost of capital. When will this happen? I don't know, but we, as consumers, will continue to buy cars and travel on airlines... It is in our best interests that the companies that provide these products/services make a reasonable profit in the process.

7 comments:

Vivek Krish82 said...

Dear Sir,
With my little understanding I have about economics, I believe that market rewards only the deserving companies to operate and survive.So its in the interest of the overall customers that only the deserving companies survive.
I know its going to be though if GM & Ford fails, but if they fail it might be because of their own practices over a long period of time, and ultimately it is the US consumer who chooses a Honda or a Toyota over a GM or Ford, so where is the question of deregulations and good companies and bad companies coming into the picture?
As far as a stable structure for returns is concerned I think every company should evaluate its own positioning in the market and formulate the structure accordingly but at the end, once again the consumers who make up the market, will decide which company gets what returns on their cost of capital.

Regards,
Vivek.

Jason said...

To reduce costs GM should consider bankruptcy. For those concerned about their retirements the Pension Benefit Guaranty Corporation (PBGC) protects the retirement incomes of nearly 44 million American workers including those at GM. Dumping the retirement cost is one way to reduce legacy costs. A bankruptcy would also give workers an incentive to take the buyouts that they have been offered. The two changes alone would save GM $24 billion a year..

1 \Who Killed GM? Will it rise again?

Saurav Roychoudhury said...

I remember that GM ranked consistently no.1 in the Fortune 500 list by Revenues (as well as in some years by profits). GM and Ford featured always in the top 5 during the same period. So things were not that bad before, so why suddenly we have the Auto manufacturers and airlines industry doing so bad now. For one thing,
These industries are characterized by huge Operating leverage and huge Financial leverage (off-course counting those Operating leases which hide the true extent of leverage). In a good economy these twin leverages help these companies to generate huge revenues and profits. But it is a lethal combination in an environment of high gas prices and rapidly declining wealth. The same twin leverages brutally work in the opposite direction.
Secondly, the GM and the Ford were complacent. Working in GM and Ford was like working in a plush public sector job in India in the 80s. Huge retirement benefits, huge employee discounts, great salaries (one difference from Public sector jobs in India)-- I know a guy from Dayton, OH in his late 20s who worked in GM to do "paint jobs" (he had a fancier title than that). His salary excluding bonuses was $120,000 in 2000. I have a friend who works in Honda in Ohio but they don't even any employee benefits (and discounts) close to what GM used to offer.

Vamshi said...

The structure in the airline industry is limited by government restrictions on foreign ownership and input factors like labor markets (pilot unions make it very difficult to outsource, at least in the US). This limits the economies of scale and lowers operating efficiencies. This could be a contributing factor for the unstable structure with poor long term returns.

Marcelo Arantes Alvim (M&A Valuing) said...

Dear Damodaran,

Your comment is very interesting and totaly true. But I´m with doubts about your information ROIC and Costo of Capital published in your website. You are commenting that the airline and automobile industries are in serius troubles because that companhies are in break even. So, we can see in your website that those industries are in very good if you to compare the ROIC and Cost of Capital.
It is very strangem, no?
Thanks
Marcelo, From Brazil

TANA said...

I want to see GM & Ford fail soo bad!! It's all about creative destruction baby!

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