GM pays to walk away

Feb 14th 2005
From The Economist Global Agenda

General Motors has paid Fiat €1.55 billion to get out of an option that would have forced it to acquire the Italian carmaker outright. This solves a small problem for GM but leaves Fiat with little time to tackle its big troubles

THE second-hand car market is relatively transparent. Buyers and sellers have readily available means to put a value on a used set of wheels. On Sunday February 13th a little light was shed on how much it would cost not to buy a second-hand carmaker, in poor condition and with one not-so-careful owner. General Motors and Fiat announced that they had undone a deal that would have forced the American car giant to acquire the 90% of the Italian firm that it did not own. GM will pay Fiat €1.55 billion ($2 billion) to cancel a “put” option that the firms had agreed as part of a tie-up that was concluded in happier times for both car companies. GM can afford this and sees it as worth paying to be rid of a car company that is losing money and market share, and is running out of road.

In 2000, GM bought 20% of Fiat Auto, the car making arm of the Fiat industrial conglomerate, for $2.4 billion. In return, Fiat took a 6% stake in the American car giant. At the time GM, the world’s biggest car company, feared being left behind in the merger wave that was sweeping the car industry. Since the DaimlerChrysler merger in 1998, the industry had consolidated rapidly. To become a global force, GM felt it needed the expertise of foreign companies to satisfy the differing tastes of the world’s car buyers and to share development costs. GM’s greatest rival, Ford, was building a global network. In Europe it eventually acquired Jaguar, Volvo and Land Rover. Renault had teamed up with Nissan. DaimlerChrysler would go on to forge alliances with Hyundai of South Korea and Mitsubishi of Japan.

GM, fearing that DaimlerChrysler would buy Fiat, resolved to add the Italian firm to its European stable, which already included Opel, Vauxhall and Saab. After the deal went through, Fiat’s then boss, Gianni Agnelli, said that he had turned down an offer of $11 billion for the whole firm in an effort to keep the reins.

Fiat was keen to sell because its decline was accelerating. Fiat Auto accounted for some 40% of Fiat Group’s sales but its losses were draining money from the more successful parts of the business. At one time Fiat had accounted for 5% of Italy’s GDP and, by the mid-1980s, it was challenging Volkswagen as the biggest European-owned carmaker. But it had made little impact beyond Europe. Mr Agnelli’s desire to keep control (and stay Italian) led to his firm missing out as other carmakers merged.

The deal with GM was the best Fiat could do in the latter stages of the consolidation bonanza. Both firms were keen to make savings through joint purchasing and by sharing engines and transmissions. But Fiat had other problems besides high production costs. It had skimped on research-and-development spending to save cash, leaving it with a stale product line-up. A reputation for poor quality deterred some buyers. Most of its sales successes were in small cars, for which margins are usually thin.

Since GM took a stake the problems have mounted. Greater foreign competition in Italy, Fiat’s biggest market, arrived as government schemes to help Fiat faded away. Fiat’s high costs and the lack of success of the Palio (Fiat’s “world car”) and the Stilo, a a bigger and supposedly more profitable model, proved a drag, sucking money from Fiat’s successful truck and tractor business. In 2002 Fiat was forced to seek refinancing in the form of €3 billion in convertible loans from banks. The souring relationship with its American partner was exemplified by GM’s refusal to contribute. Fiat also sold its stake in GM and its financing arm to raise cash. This diluted GM’s holding in Fiat to 10%, which according to GM invalidated the put option.

GM has also had its share of troubles since its link-up with Fiat. In January 2000 its shares were worth over $80 and it made a profit of $5 billion that year. Its shares now trade at around $37 and although it made $3.6 billion in 2004, $2.9 billion came from its finance arm. The world’s carmakers have the capacity to produce about 80m cars and other light vehicles a year. Yet production is running at barely 60m, in an industry where utilisation rates need to top 80% to ensure decent profits. GM’s bonds are at a record low, hovering just above junk status and it has been saddled with mounting “legacy” costs from its employee health-care and pension plans. European and Asian producers dominate America’s luxury-car market and the increasingly bold and innovative South Koreans are attacking the market for cheaper cars.

Nevertheless, GM can afford to pay Fiat to ditch the deal, from its cash reserves of some $23 billion. Taking on Fiat and its hefty debts would surely have damaged GM’s precarious credit rating. And GM needs less European capacity, not more—it recently announced a restructuring programme that will cut 12,000 jobs at Opel in Europe. Its tie-up with Daewoo gives it a better position to take advantage of the growing markets of India and China.

The future for Fiat is much less certain. The car company is burning through cash at the rate of €1 billion a year. In 2000, the year of the GM deal, it sold 2.4m cars and vans; in 2003 it sold just 1.7m; and figures for 2004, which are released at the end of February, could show a further decline. The cash from GM will buy Fiat some time to engineer a revival—or better manage its decline. Italy’s government, the first port of call for ailing national businesses, has said that it will not bail-out Fiat. It may not be able to resist political pressure to do so in the event of a crisis, though European competition law may stand in its way. In fact, Fiat is a firm with few obvious attractions. The big car companies have all the partners they need. Fiat cites Peugeot Citroën as a role model but its troubles are worse than those its French counterpart was suffering before its turnaround. A possibility is that Fiat might find salvation from Asia. A big Chinese car firm is in takeover talks with Britain’s MG Rover. Perhaps another might consider Fiat as an ideal European partner. If not, its prospects look very bleak.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.