Managing operating exposure: A case study of the automobile industry
Kim, Yong-Cheol
The dynamic interaction of currency exposure and management of exposure makes the measurement and management of operating exposure less transparent. This article presents a case study of various measures of foreign investment, such as plant location taken by automobile firms including BMW to demonstrate the complex nature of dealing with currency exposure.
INTRODUCTION
Measuring and managing operating currency exposure is difficult at best. Prior research finds that this exposure depended on the characteristics of the industry (Bodnar and Gentry 1993), firmspecific operating activities (Jorion 1990; Choi and Prasad 1995), and the relative strength of the dollar vis-a-vis the relevant foreign currency (Choi and Prasad 1995). The valuation effects on a firm from corporate foreign investment decisions depend on accounting versus economic effects, and home versus foreign market effects (Choi 1986). It has also been shown (Kim 1997) that the effects on firm value from foreign expansion or retraction is different by industry, by changes in exchange rates, and by the degree of foreign involvement before events.
Unlike transaction and accounting exposure, managing operating exposure involves all the aspects of a corporation, including financial, marketing, management, production, and others (Shapiro 1996). Choi (1989) pointed out that international investment is one of major instruments of managing operating exposure. Kim (1997), by analyzing stock price reaction of corporate expansion and retraction from foreign operation, showed empirically that managing real exchange risk and gains from diversification are major motivations of corporate international investment.
The dynamic interaction of currency exposure and management of exposure makes it difficult to understand the full nature of operating exposure. A case study would demonstrate the intricate nature of operating exposure by listing various measures of managing currency operating exposure in detail. The purpose of this article is to present the complex nature of operating exposure by focusing on the management of operating exposure of the automotive industry in general, and in particular, German Bayerische Motoren Werke (BMW) along with Mercedes, Ford Motor Co., General Motors, and Japanese Honda.
We first show the competitive nature of the passenger car industry by showing the production distribution between home and foreign countries. Various decisions taken to manage operating exposure are discussed in the subsequent sections. Those measures are plant location, joint ventures, mergers and acquisitions, product sourcing and input mix, productivity improvements, pricing strategy, product strategy and market segmentation, and the incentive package given by the state of South Carolina to BMW.
WORLD PRODUCTION OF THE PASSENGER CAR
Table 1 shows the world car production by country and company in 1994 and 1998. It shows the production for each company in its home country and the extent of their overseas production. In 1994, with the exception of Volkswagen, most of the European automobile manufacturers were producing a majority of their cars in their home country. This may show that Mercedes and BMW thought that the luxury cars they produced were less competitive and less vulnerable to exchange rate changes. All three United States (US) automakers produce half or less than half of their production from their domestic operations. In contrast, Japanese automakers show different production locations. Honda produces 55 percent of its cars at home while Isuzu produce 95 percent of its cars at home. Emerging Korean automakers are producing most of their cars a home.
PLANT LOCATION
In 1992, BMW announced it would build an assembly plant in the US, only the second European carmaker ever to do so. (Volkswagen AG closed its US factory in 1988.) The Greer, S.C., plant, which opened in 1994, will eventually produce 90,000 vehicles annually, with more than half of them to be exported to more than 100 countries, including Germany. The decision was in large part a result of the long upward march of German deutschemark. The deutschemark, worth $0.34 at 1985 exchange rates, had climbed 88 percent to $0.64 by 1992, seriously threatening the ability of BMW to compete in the United States. A BMW that sold for 50,000 marks in Germany in 1992 sold in the United States for $32,000. It would have cost only $17,000 if the peak strong dollar exchange rate of 1985 had still held.
US sales of BMW fell from a peak of 97,000 in 1986 to just 57,000 by 1991. Also contributing to the spiral was the high production costs in Germany. The approximately $27 per hour in wages and social benefits paid to auto workers in that country are among the highest in the world. In its discussion of the new plant, the 1992 annual report of BMW describes, “It is no longer possible to absorb the effects of the low exchange rate of the dollar, and the extremely high increase in production costs, merely by stepping up productivity in Germany.” BMW was convinced the United States would retain its cost advantage over Germany for a long enough time that the company could recoup its $400 million investment. The company forecasts that production costs in America will be about 30 percent below that of Germany. Each of the 1,500 workers at the Greer plant costs BMW about $40,000 a year, barely half of what an employee cost the company in Germany.
In 1994, BMW announced its second foreign manufacturing plant in Mexico. BMW said it would invest $180 million to set up an assembly plant and distribution arm in Mexico, as a way of tapping into rapidly growing car sales in Latin America. And the company said it wouldn’t stop there. “No doubt, BMW will open other facilities like this around the world,” said Bernd Pischetsrieder, BMW’s chairman. Also in late 1994, BMW began seeking up to $200 million more in financing to cover additional tooling costs at the Greer plant. Over the next decade, the plant could be building up to six different models.
In 1993, Mercedes Benz also announced a decision to build its first US plant in the state of Alabama. As with BMW, labor costs and currency risks were the primary motivation for the decision.
Ford Motor Co., General Motors and Honda have all established substantial production in Mexico, where labor is cheap and high quality. The automaker view Mexico as a vital export platform for sales of cars to rapidly growing Latin American markets. Similarly, Ford and GM are expanding in Asia, where labor also is much less expensive than in the United States. Although car sales in the region have slowed from their 25 percent annual growth of the late 1980s, Asia is still the hottest car market in the world, with annual sales increases in the high single digits.
The diversification provided by having production capacity in various countries reduces an automobile manufacturer’s economic exposure. If the real exchange rate declines in one country, the company can shift a larger portion of production to there and increase exports to countries where the real exchange rate has risen. Table I clearly shows that home production for most companies declined from 1994 to 1998. Interestingly, Mercedes went from 100 percent home production to 90 percent over the period, and slightly surpassed BMW in overseas production on a percentage basis.
JOINT VENTURES
Establishing new factories overseas can be a risky and expensive proposition. Many automakers (and companies in other industries) have chosen another route for international expansion, namely joint ventures. Joint ventures, partnerships with other companies or sometimes with governments, are less expensive, since the capital costs of starting foreign production are shared with the partner. They also can allow smaller companies larger economies of scale when buying supplies. But most importantly, companies can link with partners having in-depth knowledge of the foreign country, such as its language, consumer preferences and business culture. They also can share in technology or manufacturing know-how in which the partner has special expertise.
Perhaps the most successful joint venture in the automotive industry has been that of Ford Motor Co. and Mazda Motors Corp. of Japan. The venture, begun in 1979, has benefited both companies via sharing of expertise — Ford in international marketing and finance, and Mazda in manufacturing and product development. Ford has used its association with Mazda to become the largest-selling foreign make in Japan, and intends to capitalize on the alliance to increase sales in soaring Asian economies.
Both GM and Ford are investing heavily in other joint ventures in Asia. GM is a partner with a Chinese company in a $1 billion luxury car and minivan project in Shanghai, while Ford is pledging $400 million in an venture with an Indian partner to build cars in that country.
MERGERS AND ACQUISITIONS
Another alternative to the establishment of a new factory in a foreign country is to acquire an existing business. In early 1994, BMW announced it would acquire 80 percent of British automaker Rover in a $1.2 billion deal. The purchase gave BMW production capacity in lowcost .Great Britain, as well as Rover’s 13 percent share of the British car market, the healthiest in Europe in recent years. It also means larger economies of scale in purchases from suppliers. The deal doubled BMW in size overnight, hiking production to around 1 million units annually. Its purchases from suppliers now exceed $13 billion, a powerful negotiating tool.
PRODUCT SOURCING AND INPUT MIX
Even before the establishment of its US plant, BMW was spending several hundred million dollars annually in North America to procure parts and materials for its German-made vehicles. Although transportation costs were higher, exchange rates and lower production costs made them cheaper to import to Germany than ‘ to acquire domestically or elsewhere in Europe. With the opening of the S.C. factory, BMW’s purchases in North America are expected to more than double, to $1 billion annually, by the year 2000. By 1995, more than a dozen suppliers had already built plants about BMW’s facility, and BMW was buying parts from S.C. suppliers for import into Germany.
PRODUCTIVITY IMPROVEMENTS
Many car companies, feeling the pressure of global competition, have begun programs to improve productivity. Ford Motor Co. is undergoing a massive restructuring, known as Ford 2000, that company officials believe can save more than $4 billion a year from volume purchases and eliminated duplication of effort. Fords intends to drastically reduce the number of different lines of cars and trucks it designs and develops worldwide. General Motors also is tying its engineering activities in the United States, Europe and elsewhere closer together. GM wants to cut its development time for new vehicles for nearly one-fifth and cut product development costs by one-fourth by 1997.
BMW already has substantially reduced the time it takes to bring new models to market. In the past decade, BMW has sliced its development cycle from seven to three years and has doubled the number of models and variations offered. Each year since 1990, the company has brought out a new type of car in its 3-Series. Compressing the development cycle has allowed BMW to incorporate the most up-to-date technology in its vehicles, while also responding faster to changing consumer preferences. These moves have helped minimize the impact of the European auto recession and also sparked sales in America. US sales of 84,500 cars in 1994 were up nearly 50 percent over 1991 sales, which was the recent lowest point.
PRICING STRATEGY
In an effort to capitalize on an anticipated rise in Mexican sales under the North American Free Trade Agreement, Ford in 1994 retrofitted one of its Mexican plants to produce cars and light trucks for the domestic and export markets. But the 1994 devaluation of the Mexican peso forced Ford to drastically revise its plans. Ford slashed the sticker price of its popular Mystique and removed leather seats and sunroofs that were popular during Mexican boom times. The moves reduced the dollar price of the car down 20 percent, though it cost 70 percent more in peso terms after the devaluation. As a result, Ford share of the Mexican market climbed from 14 percent in September 1994, to almost 19 percent a year later. The goal, to maximize sales in a depressed market, succeeded.
Often, however, companies raise, rather than cut, prices in countries whose currencies have depreciated. Despite a sales slump, Honda in 1993 raised the prices of its cars sold in the United States twice in just three months. The hikes where aimed at countering profit pressures stemming from the record strength of yen against the yen.
PRODUCT STRATEGY AND MARKET SEGMENTATION
BMW’s 1994 purchase of Rover expanded the company’s product offerings in several ways. It gave BMW:
Immediate entry into the booming market for off-road sporting vehicles, a market segment the company had longed wanted to enter. (BMW intends to produce higher profits quickly by promoting the Land Rover name aggressively in the United States, where 40 percent of all vehicles sold are off-road fourwheel-drive vehicles or pickup trucks.)
Offerings in small, front-wheel-drive cars, where much sales expansion is forecast.
An entree into less expensive cars that can be sold under the Rover name with no adverse consequences for BMW’s luxury image.
In making the Rover purchase, BMW recognized that the strong D-mark limited its ability to compete on price for its own line of cars. It would continue to market BMWs on the basis of quality and styling. But the Rover acquisition gave it greater product strategy opportunities. BMW intends to expand Rover distribution to the European continent, where Rover now has almost no sales, and step up its US marketing effort as well.
INCENTIVE PACKAGES
In many cases, a local government gives incentives to attract foreign firms, including tax incentives and other benefits. BMW got such incentives from the state of South Carolina, and these were major factors in the decision to locate the new production facility in South Carolina. Estimates of the value of tax reduction and other incentives provided to BMW range from $130 million to $200 million. The State of South Carolina in 1992 estimated the value of the package used to attract the German automaker at $130 million. And while that number likely will end up being conservative, it is the best-supported number in terms of known costs.
Here is how the State Department of Commerce in 1992 said the value of the incentives breaks down:
$36.6 million used by the state to purchase 900 acres for the BMW manufacturing site, which is adjacent to 1-85 in Spartanburg County. The property will be leased to BMW for 30 years at $1 a year. After that, the company can buy the land at the state’s original purchase price.
$22.5 million for infrastructure development. This amount paid for site preparation, water and sewer, highway improvements and the expansion of the runway at the Greenville– Spartanburg Airport.
An estimated $70.7 million in state and local tax incentives over a 20-year period.
Before BMW announced in 1992 it would come to South Carolina, the company worked out an agreement under which it pays county property taxes based on a 6 percent assessment ratio, instead of the 10.5 percent yearly tax rate most businesses pay. This arrangement reduces the company’s county tax bill by about 43 percent over 20 years.
The state’s figure did not include two other relevant costs, however:
1. About $4 million earmarked by the state to train about 2,000 workers for BMW;
2. About $14 million in interest on bonds issued by the state to buy property for the plant.
Adding these two costs to the state’s estimate of $130 million would bring the total value of the package to about $148 million. Of course, none of these costs have been discounted to their present values. The state’s figures also do not include $100 million, mostly in federal funding, for widening interstate highway 1-85. BMW was only one factor on the decision to widen the highway, but the company will certainly benefit substantially front the project, which began in 1997.
BMW also was asking for additional tax breaks on a new $200 million expansion it has in the works. It wants to reduce the rate under which it would pay property taxes on the expansion from the 6 percent instituted in 1992 to 3 percent. A bill in the S.C. General Assembly at the time would have allowed BMW to receive such a break, if Spartanburg County decided to grant it. The bill, strongly supported by Governor David Beasley, did not pass, but it is said to have a good chance of passage next session or possibly in a special session of the Legislature to be held later.
Likewise, Mercedes received over $250 million in tax breaks and subsides from the State of Alabama. It marked one of the biggest incentive packages ever assembled in the US.
CONCLUSIONS
The dynamic and complex nature of dealing with operating currency exposure makes it difficult to understand it fully. Typical rigorous academic research investigates mainly the major economic factors and the effect on firm value by analyzing firms by industry, firm specific characteristics and changes in exchange rates. While there are certain common factors across firms, one of the best ways of understanding operating exposure would be to look at detailed events by focusing on a case study. This article showed various measures taken by automobile manufacturers. The study of different industries and firms in relation to the changes in the global economy would add more interesting case studies.
REFERENCES
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Choi, Jongmoo Jay (Spring 1989), “Diversification, Exchange Risk, and Corporate International Investment,” Journal ofInternational Business Studies, 145-155.
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Jorion, Philippe (1990), ” The Exchange-Rate Exposure of US Multinationals,” Journal of Business 63(3), 331-346.
Kim, Yong-Cheol (1997), “Stock Price Reaction to International Investment and Divestiture and Management of Currency Operating Exposure,” Journal of Economics and Business 49, 419-437.
Shapiro, Alan C (1996), Multinational Financial Management 5h ed. Prentice Hall Inc., Englewood Cliffs, N. J.
Yong-Cheol Kim Clemson University Robert McElreath Clemson University
Copyright College of Business Administration. University of Detroit Mercy Spring 2001
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