Industry Insight: Can Cars Be Profitable?

DETROIT ( TheStreet) -- After the collapse of General Motors ( GMGMQ) and Italian automaker Fiat's investment in the bankrupt Chrysler, the American car industry looks completely different from just a year ago.

With Ford ( F) being the only company still financially viable from the Big Three, foreign companies' shares have become investors' main options. However, even the relatively strong Honda ( HMC), Toyota ( TM), Volkswagen and Nissan ( NSANY) have suffered huge declines in sales.

The question is: Is it possible for any car maker to turn a profit big enough to satisfy investors? After all, car sales tumbled 35% in the first six months of the year. While the drop has been less severe for foreign manufacturers, their sales are still down 25% on average.

Competitive factors in the auto industry are massive and put a big damper on profits. Consider the following factors influencing the industry before betting on car stocks:

Degree of Rivalry: The average person off the street would have a difficult time naming all the car brands available in America today. There is a dizzying array of vehicles for sale, many of which are simply variations on other offerings by the same company under a different brand name. In an effort to develop a brand for every conceivable consumer, the auto industry has become an overly crowded market that can't get out of its own way.

Fierce competition in the industry has led to an ever-decreasing ability to produce a profit. Companies regularly cannibalize their own sales with identical models across brands and flood markets with more dealerships than an area can support. With a credo of "more is more," it seems the car industry is content with fighting tooth and nail for sales rather than working smarter on better products that meet customers' needs.

Even in the one-two punch of the recession and credit crisis, some companies have missed the boat on American consumers' shifting taste toward smaller and more fuel-efficient cars. As this error is corrected over the next few years, Chrysler will begin building cars using Fiat's smaller platform. Expect competition to intensify.

Bargaining Power of Customers: The incredible number of options in the auto industry leads to an extraordinarily powerful customer. Car makers with multiple production lines generally end up competing against themselves to the benefit of the consumer. A ready supply of dealerships in most commercial areas and the Internet allow for quick and effective comparison shopping and negotiating by customers.

Before the meltdown, certain car models that were highly desirable, such as the Toyota Prius, had waiting lists months long and customers willing to pay over the sticker price to take one home. Now, with sales slowing, the ball is in the customer's court. Car salesmen desperate to make a sale have been offering big price cuts, zero-percent financing and various free add-ins at the expense of the bottom line.

Customers have turned to used cars, further lessening demand during these lean times. Walking into a showroom today, a customer's power is palpable. Profits will continue to be squeezed.

Bargaining Power of the Suppliers: One benefit of a sluggish economy is that suppliers will be scrambling for every sale, leading to attractive prices. Major inputs to auto manufacturers such as steel and plastics are commodities, which carry almost no switching costs if one supplier becomes difficult to work with or expensive.

Auto workers are a far more finicky input to the production of cars. Some would argue that United Auto Workers contracts are a major reason for the pain in Detroit. Those ultra-powerful unions have managed to negotiate contracts that make strategic moves cumbersome and expensive, reducing companies' ability to compete.

The added cost of union workers, often reported as about $30 per hour more than non-union workers, didn't help Detroit carmakers' business when competing with non-union manufacturers such as Honda and Toyota. Now that the UAW is a major owner in Chrysler and GM, it's likely that those costs will stick around for the American car companies, resulting in a huge advantage for foreign makers.

Threat of New Entrants: Most new entrants will come from overseas in the next few years. Fiat plans to return to the U.S. market through the Chrysler distribution network -- hopefully without the stigma that its name stands for "fix it again, Tony."

GM plans on retaining only a few choice brands while selling or discontinuing others. This contraction should lead to a pared-down and probably more efficient industry. Customers will likely benefit from the availability of better and cheaper cars due to the weeding out of brands.

There may be fewer competitors in the future, but they will be of higher quality, forcing them to improve their output to stay relevant. That can be a positive thing, should the manufacturers embrace the challenge and rise to meet it. During the transition, performance could be rocky for those currently behind the curve.

Threat of Substitutes: Substitutes are a minor threat in America. As one of the most car-dependent countries on the planet, alternative modes of transportation can only steal away a small fraction of the market.

While high energy prices will always drive some to trains or bikes, the vast majority of consumers won't sacrifice their cars due to increased costs -- within reason, of course.

Many car companies never updated their strategies to meet the changing American consumer. Performance may be ugly while this change is implemented. For companies that do get it, sales will likely remain soft while the economy recovers.

Alas, now is not the time to bet on big-ticket items such as cars.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.

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