3 Types of Risk Facing Automakers

By Markets Fool.com

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Toyota's Corolla is one of the world's best-selling cars. Toyota's huge global scale gives it big advantages -- and creates risks for smaller competitors. Source: Toyota.

What kinds of risks do automakers face?

Making cars -- profitably -- isn't an easy business. The capital investments required are exceptionally high, the profit margins tend to be pretty thin, and the competition is fierce.

What's more, consumers are fickle. Cars are big-ticket items, and they're not commodities: The factors that make one car model more successful than another are often subjective and subtle, impossible to measure and quantify.

This all makes investing in the car business a deceptively complicated endeavor. But some of the biggest risks facing the automakers (and their investors) are straightforward. Here are three.

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Economic risks facing automakers
This is the biggie. Auto sales rise and fall with economic cycles. When times are tight, people (and companies) postpone new-car purchases. That squeezes the automakers' profits, of course.

But what might not be obvious is that it doesn't take a huge drop in auto sales to put big pressure on automakers' bottom lines, because automakers have huge fixed costs (factories, tooling, workers) that have to be paid no matter how many cars they sell in a given quarter. Executives at General Motors say that the company's North America region (by far its most profitable) will break even or profit as long as the rate of U.S. light-vehicle sales is above 10.5 million a year. ("Light vehicles" include cars, SUVs, and pickups, but not heavy trucks.)

That would be a big drop from where we are today. April's U.S. light-vehicle sales came in at an annualized pace of about 16.4 million, according to industry trackerWardsAuto. But it's not an unfathomable drop: Automakers sold 10.4 million light vehicles in the U.S. in 2009.

Automakers like GM, Ford , and Toyota are all global giants, but all derive a significant percentage of their profits from sales in the U.S. A steep recession here would squeeze them very hard.

For GM and Ford, at least, the good news is that both are much better equipped to get through a steep recession now than they were in 2007, the last time the market was riding high. Their stock prices and profits would suffer for a while, but both are now well equipped to weather a bad economic storm. Their survival would (probably) not be in question.

But for a company like Fiat Chrysler Automobiles , which has thinner profit margins (and thus a narrower margin of error), a big or protracted U.S. recession could have dramatic consequences.

Scale risks facing automakers
What else can squeeze an automaker? Several right now are feeling the pinch of economies of scale -- that is, theirs aren't as big as rivals'.

The basic calculation is simple: The more cars you sell, the lower your fixed costs per car, the fatter your profit potential. That's why the two biggest automakers in the world, Toyotaand Volkswagen , had huge pre-tax profits last year -- at current exchange rates, $14.1 billion at VW and an eye-popping $23.1 billion at Toyota.

GM is close to those two in size -- all three sold well over 9 million vehicles worldwide last year -- but its profits have lagged. That's because past GM management teams have not been good at harnessing the company's global scale. CEO Mary Barra is changing that, and the profit gap (compared to VW, at least) should close significantly over the next few years.

Companies a bit further down the size rankings, like Ford and Honda , probably have sufficient scale to stay competitive with the three giants. And luxury-car makers like BMW are able to generate fatter profit margins, meaning that they can be successful (and continue to make big investments in future products) at lower levels of sales.

But it gets tricky for the mass-market carmakers a bit further down the ladder. This is why Fiat Chrysler CEO Sergio Marchionne keeps talking about wanting a merger partner -- his company may lack the scale to compete effectively with the giants over time.

It's also why some analysts continue to be skeptical of Tesla Motors' long-term prospects. The feisty Silicon Valley start-up has done fairly well so far by sticking with luxury-priced models, but as it moves toward the mass market, it may find itself undercut significantly by companies like VW and GM, both of whom are moving to compete more directly with Tesla.

Disruption risks facing automakers
Speaking of Tesla, some folks say that Elon Musk's crew has "disrupted" the auto business. Not so: They've certainly joined the auto business, they've given the big players a lot to think about, but they haven't disrupted the existing model of building and selling cars. (And they likely won't, at least not anytime soon.)

It's possible that someone could, though. The most likely possibility is probably Apple, which could be working on an automated ride-sharing service. With Apple's huge cash hoard, design chops, and brand strength, it could --could-- design and build a fleet of cars that would entice a lot of people to give up the hassles of car ownership in favor of a seamless, friendly, high-tech service.

That probably wouldn't kill the car business entirely. But it could leave the big automakers feeling a lot like BlackBerry and Nokia feel about smartphones nowadays: left behind.

The article 3 Types of Risk Facing Automakers originally appeared on Fool.com.

John Rosevear owns shares of Apple, Ford, and General Motors. The Motley Fool recommends Apple, BMW, Ford, General Motors, and Tesla Motors. The Motley Fool owns shares of Apple, Ford, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.