“Cue “Murphy’s Law”. What can go wrong will go wrong” 

You’ve scrimped and scraped and denied yourself  those

little extras to pay off the bank. The credit cards are finally down to zero. You sit back, smugly. It feels good. Then Kerpow! The boiler explodes or the pink slip hits or a tornado strikes and its back to the familiar routine of struggling to make ends meet.

European manufacturers are currently in the smug zone. They are better placed than usual to weather the upcoming storm. Their prospects could be the definition of a virtuous spiral. Fixed costs have been brought down, productivity is impressive, and capital spending has been reined in.

“Auto workers are 30 per cent more productive than in 1997, yet are paid exactly the same wage in real terms. The industry has spent $36 billion less in capital spending since 2003 than in previous years,” said investment banker Credit Suisse in a report.

Innovations like component sharing promise a further saving of almost $20 billion by 2010.

Cue “Murphy’s Law”. What can go wrong will go wrong.

Firstly, there are the gathering economic storm clouds.

The IMF’s recent World Economic Forecast reckoned that Europe’s economy would slow to a growth of only about 1.4 per cent in 2008 and 1.2 per cent in 2009, while the U.S. grinds down to barely perceptible forward motion.

“downsize their products to virtual golf carts, with the luxury makers allowed to make buggies with go-faster stripes and leather seats”.

That’s not great news, but doesn’t look particularly threatening. And economies, despite British Prime Minister Gordon Brown’s claims to the contrary, always move between boom and bust or at least gyrate between trough and peak. (Brown, during his 10 year tenure as Britain’s finance minister, taunted the opposition Conservatives with the claim that boom and bust was a phenomenon which his policies had banished for good. So much for hubris).

“We believe industry margins of the European automakers should prove less volatile than past cycles would suggest,” Credit Suisse analyst Arndt Ellinghorst said in the report.

Sky is falling
But having worked themselves into a winning position, the sky is about to fall on European manufacturers, and from a political, not just an economic, quarter. The European Union (E.U.) is close to introducing a fuel economy regime that will decimate the premium car makers’ profits, and wipe out the miniscule amount of money mass car makers can still generate. All will face huge investment bills to downsize their products to virtual golf carts, with the luxury makers allowed to make buggies with go-faster stripes and leather seats.

Standard and Poors (S&P), the U.S. rating agency, agrees that the European have made impressive strides to put their financial houses in order, including moving production to cheaper places like Eastern Europe and emerging markets, faster new-product launches, and quality improvement. But S&P points out that if you add up the overall sales projections for European car makers, they total about 20 per cent more than the actual sales expected. S&P also sounds the alarm about the upcoming “green” regime.

“Proposals by the European Commission (the E.U.’s executive) to impose steeply rising fines on new cars that exceed tough carbon dioxide (CO2) emission targets from 2012 pose a significant threat to auto manufacturers’ profitability,” S&P said in a recent report.

Theoretical $14 billion fine for VW
“On the basis of its current emission levels and units sold in 2007, for example, Volkswagen (Europe’s biggest car maker by sales) would pay more than $3 billion in penalties in 2012, rising to about $14 billion in 2015,” S&P analyst, Frankfurt, Germany based Maria Bissinger said.

“With automotive profits for some volume manufacturers as low as $800 per vehicle, such premiums would clearly make a significant dent in their financial performance,” Bissinger said.

Bissinger concedes that the likes of VW will take steps to lighten their cars and make them more fuel efficient.

“However, it does illustrate the scale of the task, …. And the swingeing potential costs of failing do so,” she says.

The E.U. wants to raise average fuel economy to the equivalent of about 43 miles per U.S. gallon. Manufacturers that fail will be subject to huge fines. The original proposal was for this regime to start in 2012; now this is likely to be postponed until 2015. European cars now, without direct pressure from governments, achieve an impressive average 35 miles per U.S. gallon, compared with about 25 mpg in the U.S. (In America, Washington has agreed legislation which will force American cars to match Europe's achievement today by 2020.)

Tata producing in the U.S.
David Bailey, Professor of Economic Policy and International Business at Birmingham Business School, agrees that the Europeans have done much to put their balance sheets in order. The industry faces stagnation as economies slow, and the continuing weakness of the dollar against the euro will make producing some luxury vehicles in the U.S. more attractive.

“BMW has already said it will shift some production there (raising output at Spartanburg, South Carolina) and I can see Tata, the new owner of Jaguar and Land Rover, setting up production in the U.S., maybe with Fiat/Alfa Romeo,” said Bailey who is currently on secondment in Italy, at the University of Bologna.

“The environmental challenge will be huge, both in terms of regulations and also shifting consumer sentiment. Regulations will in the short-term increase costs and put European manufacturers at a disadvantage. This will of course impact especially on the big luxury producers,” Bailey said.

Struggling to see a silver lining, Bailey said at least tough CO2 rules might give Europeans a competitive advantage if and when the rest of the world decides to penalize their industry in the same way.

Emmanuel Bulle is a senior director at Fitch Ratings in Paris, France. Bulle agrees that the European industry is in good shape but he is cautious about the road ahead. He applauds the progress made on profit margins, cash generation, lower costs and efficiency, and likes the analogy that, as in engine technology, the manufacturers are getting more from less.

“I’d describe it a bit like the way the manufacturers are using turbo chargers to get more power from smaller engines, to get more out of less really. Trying to deliver higher operating profit margins, but using less resources, less cost,” Bulle said.

Tiguan
(VW is extracting more power from small petrol engines using direct injection twin-turbo technology on the 1.4 litre gasoline motor powering its Tiguan compact SUV. The technology squirts fuel under high pressure into the cylinders and uses two turbos - a light, belt driven supercharger at lower engine speeds and a bigger turbocharger which kicks in later. This eliminates turbo lag and gives high torque too. The engine produces 150 bhp, akin to a much bigger capacity unit of at least 2 litres).

Bulle worries about the cost of meeting E.U. CO2 environment rules, but is more concerned about the possible impact of raw materials costs, like steel and copper.

“The danger is that all the improvements in cost reduction might be eaten up by future raw materials cost increases. That’s a big concern,” Bulle said.

Bulle also points out that it has been a long time since Europe faced a big cyclical downturn in auto sales. Since the big fall in 1993, reverses have been small and easily contained. The sudden development of sales in Eastern Europe has mitigated weakness in the West, but these new markets are likely to be more unreliable and volatile than in traditional markets.

Ready markets for Europe’s premium cars
Eric Wallbank, U.K. automotive sector leader for Ernst & Young, reckons that whatever is decided by the E.U. in terms of CO2 regulation, the likes of BMW, Mercedes, Porsche and Audi will still find ready markets in Russia, China and a lesser extent India, for their high-price, exotic machines. He is not convinced that the regulations which do emerge and expected towards the end of 2008, will necessarily be so aggressive as the proposed changes, and like Birmingham Business School’s Bailey, sees this is as a possible long-term bonus for Europe.

“Because of the traditional high fuel costs in Europe, and the possible sharp tightening of emission standards, this will force Europeans to develop leading edge technology which should enable it to very successfully compete on the global stage when (if) others decide to do the same thing. They will be in fantastic shape to deal with the same pressure in other markets around the world,” said Wallbank.

In the Credit Suisse report, analyst Ellinghorst, concedes that intensifying competition and weakening consumer spending because of the slowing European economy may mean profit targets in 2009 and 2010 might be missed.

“What is less clear to investors is that automotive profits are structurally better placed than in previous downturns – even in the mass market. The auto sector has an ugly history of severe margin volatility, with precious few examples of any car maker consistently returning its cost of capital for more than a year.”

More resilient
“However, we think the industry is now better placed to weather the reduced volume and tougher pricing environment that inevitably accompany an economic slowdown. With lower fixed costs and rapidly expanding profit streams from emerging markets we expect automotive margins to prove more resilient than in past cycles,” Ellinghorst said.

Let’s hope that the rules to save the “green” environment don’t put a monkey wrench into that theory.