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New Cafe Rules Might Hit German Profits; Force Mergers

Fines Will Be Too Big, So Expect Premium Makers’ Mix To Suffer
BMW, Mercedes Might Be Forced To Into Predator Hands

New, uncompromising U.S. CAFE rules aimed at cutting automobile fuel consumption might savage German premium manufacturers’ profits so badly they might eventually be forced to merge with mass car makers, according to Bernstein Research.

German manufacturers like BMW, Mercedes and Porsche have avoided Corporate Average Fuel Economy (CAFE) rules in the past by simply paying fines if some of their worst gas guzzlers failed to make the cut.

Max Warburton, auto analyst with Bernstein Research, said U.S. new draft rules published on September 28 appear to take away the flexibility of fine-paying by insisting that the rules be met; period. There is also the possibility that fines may be allowed, but they will be so big as to be unaffordable.

However there seems to be some question of final authority in the setting of the new rules, which might give some relief to the Germans. The Environmental Protection Agency seems to be taking a hard line, the National Highway Transportation Safety Administration a less harsh one.

“The proposed rules are much tougher than we anticipated – with the loopholes and “lead time allowances” we expected now very limited in extent. We had assumed the Germans would be given plenty of flexibility and time to hit the new standards. It now seems like they will have to improve MPG (miles per gallon) far faster than we anticipated starting in 2012 and will have to achieve full compliance by 2015.” Warburton said.

Look impossible
The German premium makers must get close to 31 miles per U.S. gallon in three years, a 25 per cent improvement over their current average mpg, and 35.5 mpg by 2016, a 40 per cent improvement. These improvements look impossible unless the Germans substitute highly profitable, highly tuned, high margin machines, with less exciting, less profitable 4-cylinder models, Warburton said.

“The German premium manufacturers’ business models and profit structures are utterly reliant on selling high-end, high-powered variants. The incremental costs of building large engines are negligible, yet the price points are vastly higher. In simple terms, the top 10 per cent of mix makes all the EBIT (profit before interest and tax) at these companies,” Warburton said.

“The Germans will need to find a way to make smaller-engined and smaller-sized cars profitable. With limited scale, that looks difficult. Structurally lower margins post recession look likely and industry consolidation or partnerships with volume manufacturers look possible,” he said.

In other words, profitability will become so diminished, the likes of BMW and Mercedes will find themselves forced to submit to takeovers by mass car makers, whose much higher volumes will allow gas guzzling cars to be averaged down to an acceptable level. Porsche, soon to be part of the VW empire, looks likely to take this route.

Meanwhile in Europe, European Union CO2 rules look set to shake up manufacturers, and Commerzbank expects this to trigger mergers in Europe amongst mass car makers in the long-term, although it doesn’t say which ones.

In a report, Commerzbank said Peugeot-Citroen and Fiat seem to be best placed to win the race to provide more fuel efficient cars. But Commerzbank said Volkswagen and Renault will win long-term because of their bigger sales.

“We do not subscribe to the common view that Peugeot-Citroen and Fiat are the natural winners of developments in CO2 regulation – rather the opposite. In our view VW and Renault are the two companies that are generating the required effects of scale,” Commerzbank said.

Neil Winton – October 15, 2009

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